Rite Aid - Vote 'Em Out On October 30th

Summary

• Rite Aid's incumbent management and board of directors have failed shareholders repeatedly.
• Insanity is keeping the same people in power and expecting a different result.
• For Rite Aid's equity to ever have significant value, it needs to be entrusted to people who take stewardship seriously.
• Shareholders have the perfect opportunity on October 30th to register their discontent by voting against all incumbents at the annual meeting.

Author's Note: We attempted to get Rite Aid's management's response to many of the substantive points raised in this article, however we did not receive any answer from their IR department to our inquiries prior to submitting the article for publication.

If Warren Buffett is correct that price is what you pay and value is what you get, it appears to us that there could be a wide disparity between the value of Rite Aid's (NYSE:RAD) equity (i.e., its intrinsic value) and its trading price (i.e., its market value). RAD common stock has been marked down nearly enough to be available at your local Dollar Store, but what is its intrinsic value? This leads us to a corollary to Buffett's maxim, namely that an asset's intrinsic value depends greatly on in whose hands such asset rests. Stefano Pessina, the CEO and largest shareholder of Walgreens Boots Alliance (WBA), obviously believed just three years ago (before current RAD management allowed the company to deteriorate) that if all of Rite Aid's assets were in his capable hands, the common equity would be worth at least of $9 per share. Clearly the stock market believes that, in the current CEO's hands, RAD's remaining assets (following the divesture of approximately 1,900 stores to WBA earlier this year) are worth just a tiny fraction of this figure, notwithstanding the significant debt paydown RAD has accomplished with the proceeds received from WBA. Nor does the fact that RAD's conflicted CEO and board of directors recently unsuccessfully attempted to sell Rite Aid out from its shareholders to Albertsons at a fire sale price mean that RAD shares would not have much more value if the company were helmed by a board and management actually responsive to the shareholders.

A perusal of the most recently filed RAD proxy statement dated as of September 27, 2018 sheds quite a bit of light on the seemingly wide disparity between RAD equity's market and intrinsic value. Our snap conclusion? It is fitting that the October 30th annual meeting is scheduled a day before Halloween, as this is a truly mind-bogglingly cynical document, full of ghouls and goblins to spook shareholders. While there plenty of tricks therein, RAD's entrenched management and board are likely to receive any treats. In fact, we cannot recall ever reviewing a proxy statement so full of spin and attempts to sidestep accountability. The fact that even a single director (let alone all five of the incumbent independent directors) could sign his or her name to this travesty of a document speaks volumes about how lost the current Rite Aid board is.

We believe that the proxy statement proves beyond all doubt that, unless the incumbents are removed from office, RAD insiders (rather than the company's actual owners, the shareholders) will be the ones benefiting from the company's business going forward. In this article, we propose to do the following: First, we will briefly review the track record of RAD's board and management, as well as the events that have led to RAD stock trading at just above a buck per share, or close to 90% below the $9/share price WBA initially agreed to pay for all of RAD's equity just a few years ago. Next, we will detail our specific findings regarding the proxy statement and what this document says about the motivations of RAD's management and board of directors. Lastly, we will make recommendations as to how shareholders can recover the true (intrinsic) value of the assets for their own benefit from the grasp of the company's current failed leadership.

The buck stops with RAD's management and board of directors

Before examining the proxy statement, let us take a brief overview of the situation. In sports there's a saying that "success or failure starts at the top" (anyone who compares the consistent success of the New England Patriots under owner Robert Kraft during the past two decades with the relentless failure of the Washington Redskins under the reign of Dan Snyder during the same timeframe can easily attest to this fact). In other words, the buck stops with leadership. These maxims apply equally to business, and in that context the buck obviously stops at the desk of a company's chief executive officer. Rite Aid's current CEO, John T. Standley, was first appointed to a senior leadership position at the company way back in December 1999, when he became Chief Financial Officer under then-CEO Robert Miller (regarding whom, please see the discussion of the Albertsons debacle below):

(source: RAD Form 8-K, January 18, 2000).

Immediately prior to this appointment, RAD's stock price was $8.25/share; on the day of the announcement, it leapt up to $11.63/share, or 41% higher (per Yahoo! Finance). By the time Standley (then the CFO) left RAD to become the chief executive of Pathmark Stores in August 2005, however, RAD's stock price had sunk to the $4 to $5 level (according to our calculations, the VWAP for that month was $4.46), down about 46% overall during his tenure (no dividends were paid during this period). After a short stint at Pathmark from August 2005 to December 2007 culminating in that company's sale to A&P (during which period Pathmark's stock appreciated modestly during a bull market; see Pathmark SEC filings here), Standley returned to RAD as its president and chief operating officer on September 25, 2008, just following the Lehman bankruptcy (see here), at which time RAD's stock price had cratered to around $1.60. At the time, RAD heralded Standley's return to the company with the following glowing praise:

At Pathmark, Standley, 45, engineered and led the successful turnaround and sale of the company to The Great Atlantic & Pacific Tea Company, Inc., (A&P) in 2007. He has intimate knowledge of Rite Aid’s operations gained during six years at the company between 1999 and 2005, serving most recently as Senior Executive Vice President, CFO and CAO. During that period, Standley oversaw the implementation of new financial controls and was integrally involved in the development of the company’s current information systems, real estate strategy and compliance programs. He also has served for the past several months in an advisory capacity to the company and will assume the role of President from Mary Sammons, who remains Chairman and CEO. As COO, Standley will replace Robert J. Easley, who is leaving the company to pursue other interests.

"John is a proven leader with a broad-based financial background, backed by hands-on operational experience in a 23-year career in the retail grocery and pharmacy industry. He spearheaded a remarkable success story at Pathmark; and while at Rite Aid earlier this decade, he was a key member of the team that helped turn around our operating results. I am confident that he is ready to hit the ground running," Sammons said.

Standley succeeded Sammons as RAD's chief executive on June 23, 2010 (see here), at which time the stock price was just $1.07, and announced the following to RAD shareholders to mark this occasion:

During the quarter, we made excellent progress on our initiatives.... We expect [our] sales initiatives, along with the continued roll-out of our segmentation strategy, to have a significant positive impact on our business long term.

Finally, despite RAD shares underperforming the S&P 500 during the two years he had been chief executive, Standley was elevated to board chairman on June 21, 2012, at which time the stock price was $1.25. On that date the freshly-minted chairman proclaimed that "[RAD's] turnaround efforts continue to be successful" (see here). In addition, the board of directors had the following to say on page 12 of RAD's 2012 proxy statement to justify this promotion:

[T]he Board reviewed its leadership structure in light of the Company's current operating and governance environment and determined that Mr. Standley should serve as the Chairman of the Board effective as of the 2012 Annual Meeting.... The Board believes that Mr. Standley's in-depth knowledge of the Company, keen understanding of the Company's operations and proven leadership and vision position him to provide strong and effective leadership to the Board. The Board also believes that a unified structure will provide decisive and effective leadership both within and outside the Company.

Thus, we discern the following pattern: despite promotion after promotion for Standley and bold pronouncement after bold pronouncement of substantial progress for RAD by Standley, the stock price has gone nowhere but down:

• Standley appointed CFO (1999): Stock price $8.25; S&P 500 at 1433;
• Standley resigns as CFO (2005): Stock price $4.46; S&P 500 at 1233;
• Standley appointed COO (2008): Stock price $1.60; S&P 500 at 1100;
• Standley appointed CEO (2010): Stock price $1.07; S&P 500 at 1077;
• Standley appointed Chairman (2012): Stock price $1.25; S&P 500 at 1335;
• Today (2018): Stock price $1.05; S&P 500 at 2772.

Since Standley became a senior RAD executive in late 1999, during which time he has occupied a C-suite spot at RAD for approximately 189 out of 226 months (or 84% of the aggregate period, not even counting the several months he acted as an unofficial "advisor" to then CEO Sammons in the summer of 2008), RAD's share price has plummeted 87% (with zero dividends being paid to shareholders during the entire period) while the S&P 500 has increased 93% (plus substantial dividends), a total underperformance of 180% plus 19 years of missed dividends. Moreover, since Standley became chief executive officer in June 2010, RAD's share price has gone nowhere (again, with zero dividends being paid to shareholders) while the S&P 500 has increased 157% (plus ample dividends). But wait, says the defender of the RAD status quo, it is unfair to compare Rite Aid's stock performance to the S&P 500, since the retail sector has been immensely challenged by the rise of Amazon (AMZN). Well, let's take a look at RAD's stock performance versus peers CVS Health Corp (CVS) and Walgreens from 2000 to the present--any further questions?

But what about the RAD's independent directors, namely Joseph B. Anderson Jr, Bruce G. Bodaken, Kevin E. Lofton, Michael N. Reagan, and Marcy Syms (who shall collectively hereafter be referred to as the "Incumbent Independent Directors"). Can RAD shareholders reasonably expect fresh ideas and bold new leadership (as opposed to Standley's clear pattern of uninspired, consistent failure) going forward from these individuals? Are any of the Incumbent Independent Directors likely to challenge the status quo at RAD, actually stand up for the shareholders and demand accountability from those occupying the C-suite? We doubt it. The 2018 proxy statement shows that these five individuals have the following tenures, respectively:

• Anderson: appointed 2005 (board tenure: 13 years);
• Bodaken: appointed 2013 (board tenure: 5 years);
• Lofton: appointed 2013 (board tenure: 5 years;
• Reagan: appointed 2007 (board tenure: 11 years); and
• Syms: appointed 2005 (board tenure: 13 years).

With an average tenure of 9.4 years (approximately equal to period since Standley returned to the RAD C-suite in September 2008), as a group the Incumbent Independent Directors are highly unlikely to supply the fresh, entrepreneurial thinking that is so desperately needed at RAD. Moreover, 3 of the 5 Incumbent Independent Directors (Bodaken, Reagan and Syms) constitute RAD's compensation committee, meaning they simply cannot be trusted to defend shareholder interests when such interests conflict with the those of management (please see below for a discussion of RAD's dysfunctional senior executive pay system).

Now it might be argued that, despite their track record of consistent failure in generating shareholder returns over the past decade-plus, we could conceivably entrust our company to the stewardship of Standley or the Incumbent Independent Directors going forward had they invested a substantial amount of their own money in buying RAD shares on the open market, thereby putting themselves in the shoes of the owners of the company. If this were the case there might be hope indeed, since insiders would feel the pain of RAD's share price declines just as the shareholders do. Unfortunately, Standley and the Incumbent Independent Directors have (apparently) been congenitally unwilling to put their personal funds at risk by buying RAD common stock. Instead, they prefer to receive their shares gratis, in the form of stock options and grants of newly-printed shares, thereby endlessly diluting the equity stakes of the remaining holders. In fact, in order to find the last actual insider open market purchase of RAD stock, one would have to go back to April 2015 when then-EVP Dedra Newman Castle courageously put $2,243 of her own money to work to purchase 300 shares (see full list of insider actions here):

Prior to this purchase we can locate precisely ZERO insider purchases after mid-2008. Thus, over the past ten years, during the majority of which RAD's equity has lingered in the sub-$2 level (i.e., the stock market's version of the bargain bin), we can locate but one lonely instance of a named RAD executive officer or director actually reaching into his or her pocket to put himself or herself in the shoes of the company's owners (and this for a measly 300 shares!). Yet somehow the current group of insiders has amassed economic exposure to tens of millions of RAD shares (according to the 2018 proxy statement, Standley alone has exposure to over 16 million shares, including options exercisable within 60 days), despite the fact that the shareholders themselves have collectively received a return equal to squat (to borrow a technical accounting term) owning their shares over the past decade. Just to make the point 100% clear, below we present a table showing the amount of RAD common stock insiders have purchased with their own money during the past decade:

Named Executive Officers and Directors in 2018 Proxy:	# of Open Market Shares Purchased During Past 10 Years:
David Abelman	0
Joseph B. Anderson, Jr.	0
Bruce G. Bodaken	0
Kermit Crawford	0
Bryan B. Everett	0
David R. Jessick	0
Darren W. Karst	0
Robert E. Knowling, Jr.	0
Jocelyn Z. Konrad	0
Kevin E. Lofton	0
Louis P. Miramontes	0
Enio A. Montini	0
Arun Nayar	0
Myrtle Potter	0
Michael N. Regan	0
Frank A. Savage	0
John T. Standley	0
Marcy Syms	0

Click to enlarge

So much for the oft-cited, yet mythical in RAD's case, "alignment of interests of management and shareholders". But at least they are consistent in their aversion for putting themselves in the shoes of the real owners of the company ("all for one...", namely themselves).

Lastly, Standley and the Incumbent Independent Directors have a documented history of employing entrenchment measures at the expense of the shareholders--when their financial interests have diverged from the interests of the shareholders, they have not hesitated to spurn the latter in favor of the former (despite their fiduciary duties to the company's owners). For a particularly egregious example, we need look no further back than early January of this year when these same individuals approved a "tax benefits preservation plan" that limited shareholders to just a 5% position in the stock. The company claimed at the time the following justification:

RITE AID ADOPTS TAX BENEFITS PRESERVATION PLAN TO PROTECT VALUABLE TAX ASSETS

CAMP HILL, Pa. (Jan. 3, 2018) — Rite Aid Corporation today announced that its Board of Directors has adopted a tax benefits preservation plan (the “Plan”) designed to preserve Rite Aid’s ability to utilize its net operating loss carryforwards and other tax attributes (collectively, “Tax Benefits”). The Plan is similar to plans adopted by other public companies with significant Tax Benefits.

Rite Aid has federal net operating loss carryforwards totaling approximately $2.7 billion as of Dec. 2, 2017. The purpose of the Plan is to preserve Rite Aid’s ability to use its Tax Benefits which would be substantially limited if Rite Aid experienced an “ownership change” as defined under Section 382 of the Internal Revenue Code. In general, an ownership change would occur if Rite Aid’s shareholders who are treated as owning 5 percent or more of the outstanding shares of Rite Aid for purposes of Section 382 (“5-percent shareholders”) collectively increase their aggregate ownership in Rite Aid’s overall shares outstanding by more than 50 percentage points. Whether this change has occurred would be measured by comparing each 5-percent shareholder’s current ownership as of the measurement date to such shareholders’ lowest ownership percentage during the three year period preceding the measurement date. As previously disclosed, Rite Aid is in the process of consummating its sale of 1,932 stores to Walgreens Boots Alliance, Inc. for $4.375 billion on a cash-free, debt-free basis. The adoption of the Plan is intended to ensure that Rite Aid will be able to utilize Tax Benefits in connection with this sale.

What is curious about this so-called "tax benefits preservation plan" is that RAD then had and now has but a single 5% shareholder, Vanguard (and most of the other significant holders are passive funds). Clearly the largest index fund company is not the type of holder one would logically worry about unexpectedly and dramatically increasing its ownership percentage so as to jeopardize the company's tax assets. So why was RAD's board so eager to put in place this plan when they did? Consider the context. Standley and the Incumbent Independent Directors had just failed spectacularly to consummate the sale of the company to Walgreens, due to opposition from the FTC, and had instead entered into an asset purchase agreement to sell approximately 2,200 stores to WBA, which number was later reduced to just over 1,900 stores (note also that the termination of the WBA merger agreement was preceded by RAD's leadership caving to pressure and agreeing to reduce the buyout price in early 2017 from $9/share to a range of $6.50 to $7/share). This failure was not simply "bad luck"; RAD's leadership horribly miscalculated the antitrust risk inherent in the transaction. So, with few options remaining and the company's EBITDA dramatically declining (probably due to management taking their eye off of the company's core operations as a result of their endless M&A distractions--remember, the Walgreens merger talks began way back in 2014), RAD entered into the Walgreens asset sale agreement in order to de-lever the balance sheet. Meanwhile the stock price plummeted from $8 to $2 during the course of 2017 as these events unfolded.

Now if you were CEO Standley, in control of RAD's board as chairman, and you wished to shut down the ability of any potential activist to hold you and the Incumbent Independent Directors accountable for the Walgreens buyout disaster and RAD's consequent stock price decline (and possibly force a sale of the company to the highest bidder), you might seek to block any such activist from amassing a large stake in the company. In addition, if you were CEO Standley and suspected your days as chief executive were numbered as a result of RAD's operational and M&A failures, you might want to engineer the sale of your company to a friendly strategic acquirer at a fire-sale price, knowing that in return the grateful buyer would ask you to stay on as CEO of the combined company. You might even ignore other potential suitors and agree to merge with a company run by your former boss (the aforementioned Robert Miller) which was staggering under a mountain of debt and owned by a private equity company desperate to find a sucker to unload it on, all of which would give the lie to the following pronouncements you made when the WBA asset sale was announced about eight months previously:

"While we believe that pursuing the merger with WBA was the right thing to do for our investors and customers, [the WBA asset sale] agreement provides a clear path forward and positions Rite Aid as a strong, independent, multi-regional drugstore chain and pharmacy benefits manager with a compelling footprint in key markets,” said Rite Aid Chairman and CEO John Standley. “The transaction offers clear solutions to assist us in addressing our pharmacy margin challenges and allows us to significantly reduce debt, resulting in a strong balance sheet and improved financial flexibility moving forward."

In order to do all of this, though, the last thing you would want would be RAD's owners (especially an activist investor with a major RAD equity stake) clamoring for a sale to the highest bidder, which might not be your chosen friendly strategic buyer (and, horror of horrors, you might thus be dismissed from the chief executive's office). In other words, if you have no real intention of answering to the shareholders, as the owners of the company, and desire a free hand to pursue your own self-interested goals of maintaining your high-paying, prestigious CEO position, as well as lucrative director spots for your most loyal rubber-stamps on the RAD board, the ideal scenario is to have stock ownership spread out as wide as possible, so no single shareholder or group of shareholders can assert their control over corporate governance. Luckily for Standley and his captured board, he had a convenient justification to achieve these ends with the "tax benefits preservation plan" (aka "management and board entrenchment device" or "poison pill"), namely the company's significant loss carryforwards and the Walgreens asset sale (in connection with which the carryforwards would be used). In our view, there was no legitimate reason to put this agreement in place at the time, given the absence of 5% owners (other than Vanguard); rather, the tax issue was simply a pretext to block anyone (especially an activist) from taking a large stake in the company.

Moreover, the timing of the "tax benefits preservation plan" is indeed curious. It was approved by RAD's board on January 3, 2018, over six months after RAD and Walgreen's announced the asset sale (supposedly the rationale for putting the plan in place). Meanwhile, page 113 of the RAD-Albertsons proxy statement discloses that "Mr. Standley informed the Rite Aid board of directors that, on or about January 4, 2018, [Albertsons] and Cerberus had approached him about serving as the Chief Executive Officer of the combined company after the closing of the merger". The "on or about" language is quite fuzzy. Could it be that the actual the post-merger CEO proposal to Standley was made by Cerberus/Albertsons on January 2nd or January 3rd (i.e., BEFORE the RAD board, chaired by Standley, approved the tax benefits preservation plan)? If true, that would be interesting indeed. Also per page 113 of the merger proxy, we discover that Standley did not even bother to inform RAD's board that this CEO job proposal had been made to him by Cerberus/Albertsons until approximately a week later (on January 10th). Regardless, if the Walgreens asset sale was indeed the motivation for the tax plan, why did RAD's board allow six months to pass before putting it into place? An obvious benefit of this agreement was to entrench Standley and the Incumbent Independent Directors while they shopped the company to an acquirer who would guarantee their continued employment. This end was achieved when RAD entered into the merger agreement with Albertsons in February 2018 (see merger PR here), following which the tax plan was terminated upon completion of the Walgreens asset sale (see here).

In our opinion it is clear from the following disclosures in that the entire "negotiation" with Albertsons was kabuki theatre at its best (or worst, depending on one's vantage point):

• As just described, sometime around January 4, 2018, Albertsons and Cerberus approached Standley about serving as the Chief Executive Officer of the combined company after the closing of the merger. Yet it was not until three weeks later, on January 24, 2018 (less than a month before the final merger agreement was executed by the parties), that Standley and the Rite Aid board of directors established a separate committee of directors (exclusive of Standley), consisting of directors Michael N. Regan, David R. Jessick and Mr. Savage (the latter of whom had his own undisclosed conflicts of interests, which should have resulted in him recusing himself from further participation in the Albertsons talks; for which see page 121 of the merger proxy), to negotiate, for the Rite Aid board of directors’ consideration, the exchange ratio and other financial terms of the transaction with Albertsons. Why didn't Standley immediately recuse himself from all further Albertsons negotiations as soon as Cerberus and Albertsons approached him about the combined company CEO role?
• Citigroup, acting as advisor to RAD on the Albertsons negotiations, appears to have had a clear conflict of interest in that it had previously acted as an advisor to Albertsons, as the merger proxy discloses on page 106: "On July 13, 2017, as subsequently disclosed by Citi to the Rite Aid board of directors and management on November 16, 2017, certain members of the Citi coverage team for [Albertsons] who meet periodically with [Albertsons] to discuss potential strategic matters and who at the time were not part of the Rite Aid transaction team (but who subsequently joined the Rite Aid transaction team), met with members of [Albertsons] management to provide a routine investment banking update to [Albertsons] with an overview of certain strategic, business and financial considerations in the retail sector, which included, among other things, a discussion of the then recently announced acquisition of Whole Foods Market Inc. by Amazon Inc. In connection with such overview, such Citi-[Albertsons] coverage team members provided [Albertsons] with certain discussion materials regarding potential strategic alternatives for [Albertsons], including, among other potential transactions, a preliminary hypothetical reverse IPO merger transaction with potential identified counterparties, including Rite Aid". Despite these conflicts, RAD's board did not replace Citi as advisor on the prospective transaction with Albertsons.
• RAD's so-called negotiating strategy with Albertsons was to take advice from its conflicted advisor Citi on the pro forma ownership percentage for RAD shareholders with respect to the combined RAD-Albertsons entity, namely 28-42% of the entity's equity, and the RAD board then inexplicably decided that their opening ask to Albertsons would not be above this range (for example, a 45-50% stake), but rather that "Rite Aid should start negotiations towards the high end of the implied ranges...with a pro forma ownership of 35-40% for its stockholders, with the understanding that the higher end of the proposed range would be difficult to obtain but a proposal at that range would be useful in negotiations." Clearly the RAD board had a defeatist approach with respect to these negotiations from the outset, apparently petrified that Albertsons might walk away.
• The Background of the Merger section of the merger proxy makes painfully clear, in our view, that RAD's board had minimal desire to conduct a real auction of the company to the highest bidder. Rather, they had their preferred suitor (Albertsons) and, at best, were apathetic with respect to engaging with other potential acquirers. For example, note the disclosure on page 111 of the merger proxy that "[o]n November 20, 2017, Rite Aid management met with Party H regarding strategic business alternatives and opportunities. Party H indicated it would discuss further and would follow up with Rite Aid if there was any interest in a potential strategic transaction. Party H did not follow up with Rite Aid". Why wouldn't RAD's board follow up on this opportunity? On page 113 of the merger proxy we learn that "[o]n January 18, 2018, Citi received a phone call from Party J inquiring about a potential strategic transaction involving Rite Aid without providing any specific information. Citi responded that if Party J had a proposal, then Citi would relay such proposal to Rite Aid. Party J never provided a proposal, any additional information or followed up with Citi or Rite Aid". Why such passivity? Did Citi even bother informing RAD of this "potential strategic information" with Party J?

Predictably, RAD's shareholders easily saw through the farcical nature of the Albertsons deal and Standley and his captured board of directors were forced to pull the plug on this one-sided transaction. Yet, despite the facts we have just described and despite the endless failure to generate any real value for RAD's owners, these same individuals are now asking for our backing to continue in their high-paid, prestigious offices, as evidenced by the proxy statement just sent to shareholders, to which we turn next.

RAD's 2018 proxy statement: Directors gone wild

At the beginning of the proxy statement, the Incumbent Independent Directors have all signed their names to a open letter to the shareholders trumpeting their corporate governance reforms at RAD, stating the following:

Since the termination of the Albertsons transaction, our Board has spearheaded a campaign to have our independent directors engage with our stockholders. Independent directors and management together have reached out to 11 of our largest stockholders, owning in the aggregate approximately 38% of our shares, and independent directors have engaged directly with six of these stockholders to date, owning in the aggregate approximately 29% of our shares. In addition, management has communicated with many retail stockholders and received their feedback. We greatly value the insightful input about Rite Aid that our stockholders have provided in these and other exchanges.

According to Barrons.com, the top 11 RAD holders currently own 480 million shares, or about 45% of the outstanding stock, as follows:

Name	Shares Held (millions)	% Outstanding	% of Assets	As Of Date
The Vanguard Group, Inc.	91.2	8.56%	0.00%	6/30/18
BlackRock Fund Advisors	65.2	6.12%	0.00%	6/30/18
Franklin Mutual Advisers LLC	51.3	4.82%	0.13%	6/30/18
OppenheimerFunds, Inc.	50.2	4.71%	0.04%	6/30/18
Oppenheimer Global Opportunities Fund	50.0	4.69%	0.66%	6/30/18
Highfields Capital Management LP	47.0	4.41%	0.64%	6/30/18
Vanguard Small Cap Index Fund	27.0	2.53%	0.04%	8/31/18
Vanguard Total Stock Market Index Fund	26.6	2.50%	0.01%	8/31/18
SSgA Funds Management, Inc.	25.1	2.35%	0.00%	6/30/18
iShares Russell 2000 ETF	23.5	2.20%	0.06%	10/4/18
Alberta Investment Management Corp.	22.6	2.12%	0.25%	6/30/18
TOTAL	479.7	45.01%

Click to enlarge

Regardless of this discrepancy (38% versus 45%), note that the three Vanguard entities listed own 13.5% collectively, so perhaps the "six [stockholders] owning in the aggregate approximately 29% of our shares" that RAD's board claims to have "engaged directly with" could be these three plus any three of the others totaling around 15-16%. Yet note how tiny the RAD positions are as a percentage of total assets for each of the above-listed holders: for seven of the eleven, RAD constitutes 0.06% OR LESS of their aggregate assets (and these numbers would today be far LOWER, given RAD's recent share price declines). Shockingly, almost one-quarter of RAD's common stock is held by four asset gatherers that are so large their RAD positions barely even register as a percentage of total AUM (and for each of the top two, it rounds to literally 0.00%!). So, despite the RAD board claiming credit for "spearheading" this outreach campaign, they are clearly talking to the wrong entities. They should instead be soliciting views of shareholders for whom a RAD position amounts to far more than 0.66% of AUM. Note also the statement that "management has communicated with many retail stockholders and received their feedback". Really? What "management" would this be, RAD's investor relations contact? Somehow we doubt that Standley or anyone else in the C-suite has been dialing up retail shareholders to obtain their views on corporate governance.

Two paragraphs further down in the letter the Incumbent Independent Directors make the bold claim that "[a]fter rigorous and thoughtful evaluation and discussion, the Board firmly believes that John Standley is best situated to serve as Rite Aid's Chief Executive Officer". Huh? Are RAD shareholders really supposed to believe that among all the possible candidates for CEO for our company in the world, of which there should be literally dozens potentially available, Standley, who has failed over and over and over again to create value for the shareholders, is "best situated to serve as Rite-Aid's chief executive officer"? How many other CEO candidates did the board of directors interview before deciding that Standley was the best option? Did they even bother to interview a single outside candidate? If so, who were these other candidates and what are their track records in comparison to Standley's dismal track record? Which executive search firms (if any) did the Incumbent Independent Directors hire to identify such candidates? Did it ever enter their minds that Standley's documented history of shareholder wealth destruction militates against allowing him to continue serving as CEO?

Finally in the letter, the Incumbent Independent Directors make the claim that the governance changes described in the proxy statement are "the first steps in reinvigorating our corporate governance practices and policies". First steps? Apparently this statement is supposed to appease Rite Aid's aggrieved shareholders, holding out the carrot of hope that future governance reforms will be in store. The obvious questions raised are the following: If there are additional steps to "reinvigorate Rite Aid's corporate governance practices and policies", then (1) what additional steps are being contemplated by the board? and (2) what in the world are the Incumbent Independent Directors waiting for? Why haven't they taken such steps already? If there was ever a time for Rite Aid's board to do the absolute maximum in reforming their atrocious corporate governance practices, the upcoming annual meeting was the perfect opportunity. But the Incumbent Independent Directors have clearly decided that whatever further steps are necessary can wait. In our view, this is simply a ploy to push off reforms as far as possible into the future and further entrench the Incumbent Independent Directors and Standley in their respective offices.

The company also makes a big deal in the annual meeting proxy statement about the fact that through their supposed refreshment process they now have increased the racial and ethnic diversity on the board. They include the following helpful pie chart on page 11 of the proxy showing how diverse they are:

In addition, they include a "skills and experience" matrix on page 12 of the proxy, as follows (look at all of the "X"s!):

Reviewing the above, apparently RAD's board of directors believes that shareholders will now rest easy considering the incredible diversity and skill sets of these directors. What the above charts do not answer, however, is whether the board is stocked with individuals (1) who actually know best how to run a drug store chain and pharmacy business and compete with the likes of Walmart, CVS and Amazon and (2) are incentivized to defend the interests of the shareholders against overreach by management. These are the two primary goals of any board of directors, not furthering overarching societal goals (however laudable) such as diversity. The bottom line is that if the RAD board actually cared about promoting the interest of shareholders and aligning the incentives of management and the directors with the shareholders, they would add as directors representatives of significant shareholders of the company. Yet this has not happened.

Next let us examine the backgrounds and ages of the proposed board of directors. First, it is logical to assume that if you and your allies control a board and you want to entrench yourselves, you would appoint independent directors nearing or past the traditional retirement age, as well as individuals likely to be financially dependent on their director's fees. You would certainly not want young and vigorous directors on your board, who might actually threatened your power. When we look at the independent directors up for confirmation at this year's annual meeting, we note a clear pattern:

Director	Age
Joseph B. Anderson, Jr.	75
Michael N. Regan	70
Arun Nayar	67
Marcy Syms	67
Bruce G. Bodaken	66
Louis P. Miramontes	64
Robert E. Knowling, Jr.	63
Kevin E. Lofton	63

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The average age of these directors is 67 (i.e., retirement age), or 12 years senior to the (relatively) youthful RAD CEO. Moreover, below we have excerpted the professional backgrounds of the three newly nominated independent directors, Knowling, Miramontes and Nayar. The first is an "advisor-coach to chief executive officers" and chairman of a company whose website doesn't appear to have been updated in about five years and does not even have a contact phone number (it merely has a gmail account under its "Contact Us" page; see for yourself at http://eagleslandingpartners.com/), the second is a retired KPMG audit partner and the third was the CFO at Tyco from 2012 to 2015 (and is now retired). Do any of these three seem likely to step up and challenge anything Standley or Incumbent Independent Directors want to do, thereby jeopardizing their yearly $220,000+ director compensation for part-time work? Moreover, do any of these three have a professional background that would give RAD shareholders confidence that they can come up with strategies to outsmart Jeff Bezos? We don't think so.

Robert E. Knowling, Jr. Mr. Knowling is currently Chairman of Eagles Landing Partners, which specializes in helping senior management formulate strategy, lead organizational transformations, and re-engineer businesses. Mr. Knowling also serves as an advisor-coach to chief executive officers. Mr. Knowling previously served as Chief Executive Officer of Telwares, a JP Morgan Chase/One Equity Partners Private Equity-owned company from 2005 to 2009. From 2001 to 2005, Mr. Knowling was Chief Executive Officer of the New York City Leadership Academy, an independent nonprofit corporation created by Chancellor Joel I. Klein and Mayor Michael R. Bloomberg that is chartered with developing the next generation of principals in the New York City public school system. From 2001 to 2003, Mr. Knowling was Chairman and Chief Executive Officer of SimDesk Technologies, Inc. Prior to this, Mr. Knowling was Chairman, President and Chief Executive Officer of Covad Communications, a Warburg Pincus Private Equity backed start-up company. Mr. Knowling currently serves on the board of directors of Convergys Corporation, K12 Inc. and Roper Technologies Inc. Mr. Knowling previously served as a director of Ariba, Inc. until 2012, Heidrick & Struggles International, Inc. until 2015, Hewlett-Packard Company until 2005 and The Immune Response Corporation until 2005.

Louis P. Miramontes. Mr. Miramontes worked at KPMG LLP from 1976 to 2014, where he served in many leadership roles, including Managing Partner of the San Francisco office and Senior Partner for KPMG's Latin American region. Mr. Miramontes was also an audit partner directly involved with providing audit services to public and private companies, which included working with client boards of directors and audit committees regarding financial reporting, auditing matters, SEC compliance and Sarbanes-Oxley regulations. Mr. Miramontes currently serves on the board of directors of Lithia Motors, Inc., one of the largest providers of personal transportation solutions in the U.S., and Oportun, Inc., a mission-driven financial services company.

Arun Nayar. Mr. Nayar retired in December 2015 as Executive Vice President and Chief Financial Officer of Tyco International, a $10+ billion fire protection and security company, where he was responsible for managing the company's financial risks and overseeing its global finance functions, including tax, treasury, mergers and acquisitions, audit, and investor relations teams. Mr. Nayar joined Tyco as Senior Vice President and Treasurer in 2008 and was also Chief Financial Officer of Tyco's ADT Worldwide. From 2010 until 2012, Mr. Nayar was Senior Vice President, Financial Planning & Analysis, Investor Relations and Treasurer. Prior to joining Tyco, Mr. Nayar spent six years at PepsiCo, Inc., most recently as Chief Financial Officer of Global Operations and, before that, as Vice President and Assistant Treasurer—Corporate Finance. Mr. Nayar currently serves on the Board of Directors of Bemis Company, Inc., a manufacturer of packaging products, and TFI International Inc., a leader in the transportation and logistics industry. Mr. Nayar is also a Senior Advisor to McKinsey & Company and to a private equity firm, BC Partners.

Standley and the Incumbent Independent Directors have not put any individual on the board of directors likely challenge them. Furthermore, page 71 of the proxy statement reveals none of the three new directors has purchased even a single share of RAD stock with their own money. How are RAD shareholders supposed to believe these three will resolutely defend our interests when they have no skin in the game? The refreshment of three directorships and removal of Standley as board chairman (and replacement with ally Bodaken) seems to be the minimal possible corporate governance "reform" that RAD's entrenched incumbents could get away with while still claiming to have made "progress".

Moving on to the discussion of executive compensation in the proxy statement, on page 40 we find the following claim:

Compensation should reward performance. Our programs should deliver compensation that is related to our corporate performance. Where corporate performance falls short of expectations, the programs should deliver lower-tier compensation.

Unfortunately, everything in the proxy statement's discussion of the executive compensation for Rite Aid's senior executives belies the statements. Not only has the compensation committee approved absurd "retention payments", they have also repeatedly lowered operational goalposts with respect to bonus payments.

Let us consider for the moment the purpose of so-called retention payments. These are payments necessary to retain the services of outstanding senior executives. In other words, such payments should be made to executives who have demonstrated historically high levels of execution and have otherwise acted in an exemplary fashion on behalf of the owners of the company. Retention payments should only be used in the rarest of circumstances. Such payments might be required, for instance, during an economic downturn similar to the financial crisis of 2008/2009, but they certainly should not be doled out to reward chronically underperforming executives in good economic times. We think that Rite Aid's retention payments are nothing but rewards for failure. Standley failed to close the Walgreens buyout, attempted (and fortunately failed) to close the flawed Albertson's merger, vastly overpaid for RAD's PBM EnvisionRx (the value of which has now been written down by hundreds of millions of dollars), and has not returned even one cent to the shareholders in dividends during his entire CEO tenure. Even worse, the company's EBITDA has relentlessly declined over the past few years on his watch, leading directly to RAD's stock price collapse from ~$8 to ~$1. Yet the Incumbent Independent Directors deemed him worthy of receiving a $3 million retention payment just two months ago? Do they inhabit an alternative universe? We are quite certain that most Rite Aid shareholders would be thrilled to gift to Standley a $3 million NON-retention payment if it would ensure his permanent departure from the company!

Moreover, the Incumbent Independent Directors should be ashamed of the adjusted EBITDA goalpost moving for fiscal 2018, described in the proxy statement as follows:

Under [RAD's] plan formula, payouts can range from 0% to 200% of bonus targets depending on Company performance. The Compensation Committee initially established an Adjusted EBITDA performance target of $1,022 million for fiscal year 2018, based on the then-current financial plan targets. This performance level target, based on the financial plan, was below our fiscal year 2017 performance of $1,137 million as a result of continuing reimbursement rate pressure and the fact that fiscal year 2018 had one (1) less week than fiscal year 2017. The Compensation Committee also established a threshold at which management could be rewarded at 50% of bonus target at achievement of Adjusted EBITDA of $869 million (85% of target), and the Compensation Committee approved a maximum at which management could be rewarded at 200% of bonus target at achievement of Adjusted EBITDA of $1,124 million (110% of target).

At its July 2017 meeting, the Compensation Committee re-evaluated the likelihood of achieving Adjusted EBITDA results above the threshold performance of $869 million after termination of the WBA merger agreement and execution of the subsequent asset sale to divest stores and distribution centers to WBA. During this meeting, the Compensation Committee determined based on the projected financial impact of the loss of certain pharmacy services contracts and the Company being excluded from certain pharmacy networks in which it participated last year, that such level of performance was extremely unlikely to be attained. Accordingly, in the interest of maintaining a strong incentive aligned with short-term performance following considerable ongoing challenges and uncertainty related to the extended duration of the potential WBA merger process, as well as no payments and projected below-target or no payments under recent and in-cycle annual and long-term performance incentives, the Compensation Committee lowered the threshold level of performance at which management could be rewarded with a bonus of 50% of target, and approved a threshold Adjusted EBITDA of $664 million (65% of target). At the same time, the Compensation Committee also decided to increase the maximum level of performance at which management could be rewarded at 200% of bonus target, and approved a maximum Adjusted EBITDA goal of $1,380 million (135% of target).

Finally, in February 2018, the Compensation Committee modified the annual incentive performance framework to reflect the impact of the reduction of Adjusted EBITDA resulting from the divestiture of stores to WBA. Specifically, the Consolidated Adjusted EBITDA target was reduced by $37 million to $985 million, threshold Consolidated Adjusted EBITDA remained 65% of target (reduced to $640 million), and maximum Consolidated Adjusted EBITDA remained 135% of target ($1,330 million).

In fiscal year 2018, challenges associated with the extended duration of the WBA merger process and its ultimate termination, the asset sale, as well as the impact of the loss of certain pharmacy services contracts and being excluded from certain pharmacy networks in which we participated last year had a substantial negative impact on our fiscal year 2018 results, and Rite Aid's actual Consolidated Adjusted EBITDA was $818 million, which was below the revised target performance level, but above the revised threshold performance level, resulting in bonus payments at 74.8% of the revised target.

So not only did RAD's compensation committee initially set an easier adjusted EBITDA target for FY 2018 ($1,022 million) than FY 2017's actual performance ($1,137 million), when it became clear in July 2017 that RAD would not even remotely approach the new (lower) target for FY 2018, the 50% bonus threshold was inexplicably lowered by 24%, from $869 million to $664 million. Magically, actual FY 2018 adjusted EBITDA came in at $818 million, allowing RAD's senior executives to receive 75% of their target bonus amounts (despite adjusted EBITDA for FY 2018 declining almost 30% from FY 2017's level!). By constantly lowering the company's EBITDA goal posts, RAD literally incentivized management to fail--which they did (in spades).

But wait, there's even more to hate about Rite Aid's senior executive compensation system. In the most recent quarter the company had to write down the value of EnvisionRx by $313 million dollars (see page 21 of RAD's Q2 FY 2019 Form 10-Q filing). However, when calculating adjusted EBITDA, the company adds back the entire EnvisionRx charge (plus other impairment charges, altogether totaling $375 million), apparently on the justification that it is a "non-cash" charge against earnings, as per the following table in the Q2 FY 2019 earnings release from September 27th:

Yet the EnvisionRx cash loss actually happened because Standley overpaid in buying the asset back in February 2015. Will Standley thus agree that it is now appropriate to go back and recalculate RAD's adjusted EBITDA for FY 2015 to reflect the cash loss that the company (unknowingly) incurred at the time of the EnvisionRx acquisition, and to which it belatedly fessed up in its writedown of several weeks ago, and thereby retroactively reduce his FY 2015 compensation to correct for any bonus overpayment? If not, then why should $375 million be added back in calculating adjusted EBITDA for FY 2019 for compensation purposes? Obviously he would never agree to any retroactive (lower) bonus recalculation, exposing how silly it is not to count "non-cash" goodwill and intangible asset writedowns when determining the adjusted EBITDA calculation in determining bonus payments going forward.

Please note that we are not alone in our views on RAD's ridiculous compensation practices. Readers should review the critique thereof supplied by the Teamsters recently (for which see here). We wholeheartedly agree with the Teamsters that "[o]ver the past year, the members of Rite Aid’s Compensation Committee, all of whom are set to remain on the board, have gone to extraordinary lengths to cushion the financial impact on executives of the strategic and operational challenges facing the company. With Standley set to continue as CEO, it is vital that shareholders send a clear signal that the board cannot continue to reward failure. Accordingly, we urge investors to Vote No on Say-on-Pay."

A few questions for RAD's leadership--and a path forward for its long-suffering shareholders

Perhaps because RAD's management and board have spent so much of their time over the past four years engaging in M&A disasters and tending to their (sadly successful) entrenchment activities, Rite Aid's core operations have been allowed to wither on the vine. We thus have the following questions for the company's leadership, which hopefully they will attempt to answer at the upcoming annual meeting:

• Where are business initiatives that would actually increase the value proposition for RAD's customers? Has management ever considered putting in self-checkout kiosks at its stores, as CVS has in many of their boxes? Probably the number one complaint brick-and-mortar retail customers have is waiting in line to pay for their items. Why hasn't Rite Aid done anything to alleviate this problem? (Obviously one of the key advantages that Amazon has over B&M retailers is that they have no check-out lines.)
• What about SKU rationalization: Where is Management's comprehensive plan on that front?
• Has management ever considered doing something innovative with the space that could be saved in Rite Aid stores as a consequence of such SKU rationalization, such as putting in seating areas for cafes? Perhaps a joint venture with, say, Dunkin' Brands (DNKN) could work. Does management have any ideas in the works on this front, or are they simply content with the failing status quo?
• Does management have any plans to capitalize on the secular growth in vaping (which could actually be a health boon if it weans people off of cigarettes)? This could potentially be a high-margin business for the company.
• Has management ever considered putting in a buy online, pickup at store option for customers? What is the cost-benefit analysis for such a program? What test programs are underway at RAD stores in connection with this option.
• What cost-cutting initiatives is management instituting to generate bottom-line returns, now that nearly half of the store base has been sold to Walgreens? Why isn't management implementing a zero-based budgeting system? Why hasn't management attacked the bloated corporate bureaucracy at headquarters? Why haven't senior executive salaries been reduced, since the company is now about 50% of its former size?
• Now that the Albertsons debacle has been canceled, why hasn't RAD's management scheduled an all-day Investor Day event to go over all the brilliant strategies and new store concepts they have to generate increased revenues and profits at the company? One would assume that if they had any such brilliant strategies and concepts (and since they have recently received huge retention payments courtesy of the board, we can only conclude that they MUST be brilliant executives), they would be champing at the bit to share them with the entire world. (We aren't holding our breath.)

In our view, real entrepreneurial thinking never seems penetrate the C-suite at Rite Aid, whose occupants much more resemble bureaucratic rent-seekers than ingenious businesspeople (such as can be found at Amazon, for instance). This probably explains why the stock chart for Amazon goes consistently up and to the right, while RAD's stock chart (at least, during Standley's reign) is unfortunately consistently DOWN and to the right.

So, what is a RAD shareholder to do now? We believe the following:

• Vote 'Em Out! At the annual meeting in two weeks, we recommend that shareholders VOTE AGAINST ALL nine of RAD's board of director nominees, especially Standley and the three Incumbent Independent Directors on the compensation committee (Proposal No. 1). We also recommend voting AGAINST approval of RAD's executive compensation system (Proposal No. 3) and IN FAVOR OF the stockholder proposal to separate the board chairman and CEO positions (Proposal No. 4). It is well past time to send a loud-and-clear message that the status quo at RAD is NOT acceptable and that the half-hearted corporate governance "reform" measures announced in the proxy statement are not even remotely close to sufficient.
• Organize. In order to receive the full benefits of ownership of the equity of the company, it is imperative that shareholders organize themselves, especially in light of the egregious entrenchment stratagems used by management to exclude shareholders from any participation in the governance of the company. Talk to each other. Communicate your dissatisfaction to the company at every opportunity. Try to interest potential activists in making a run at replacing RAD's current failed leadership. Demand that RAD put representatives of large shareholders on the board. Remember, Rite Aid belongs you YOU, not to CEO Standley or the Incumbent Independent Directors.
• Once we get new leadership at RAD, the executive compensation system must be totally revised and replaced with a system that actually motivates the executives in the C-suite to work on behalf of the shareholders, rather than on behalf of their own financial interests. In addition, the so-called compensation consultant that RAD hired for the most recent fiscal year needs also to be fired ASAP. Whatever advice this consultant gave to the compensation committee had virtually no value in bringing about a rational compensation structure.

Conclusion

We believe that Rite Aid has very valuable assets, but this value is currently obscured because they are in the hands of a failed CEO and the uninspiring Incumbent Independent Directors, who should all be replaced. If RAD's assets were worth $9/share to Walgreens in 2015-2017 (before approximately half of the supposedly less desirable--at least, according to Standley--assets were sold to Walgreens), what might the company's assets be worth today to a certified entrepreneurial genius such as Jeff Bezos (who wants to open 3,000 cashierless stores by 2021)? What would they be worth to a Walmart (WMT) or a CVS or a Target (TGT), companies with the scale to reduce SG&A and other costs as a percentage of revenues? What about to a private equity company specializing in turning around retail companies? Certainly vastly in excess of a dollar and change, the value currently ascribed to RAD shares by the stock market. But obtaining this value starts with the shareholders. And it starts on October 30th by voting a resounding NO on all of RAD's director nominees, as well as voting AGAINST approval of the broken senior executive compensation system. Every marathon begins with a single step, and the first one for RAD's owners takes place just under two weeks.

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.