Rite Aid: Promises To Shareholders Not Kept

Feb. 06, 2019 1:10 PM ETRite Aid Corporation (RAD)CVS, PIRRQ, WBA428 Comments

Summary

  • Last September, Rite Aid promised that the separation of the CEO and Chairman roles was just the "first step" in corporate governance reform at the company.
  • Since then, the company has been silent on further governance reforms.
  • The recent reverse split proposal appears to us yet another shareholder-unfriendly entrenchment device employed by the board and management.
  • Rite Aid can never fulfill its potential unless it attains best-in-class governance. Fortunately, the company is now a promising target for activist investors.

Shares of Rite Aid (NYSE:RAD) recently plumbed multi-year lows, dropping to $0.60/share in late December and $0.79/share as of this writing (levels not seen since the 2008/2009 financial crisis), down from a high over $8.50/share as recently as January 2017 and the $4.50 to $8.50/share range in which the stock consistently traded during the three-year period from 2014 through 2016. We provided our views on why Rite Aid's management and board of directors have comprehensively failed shareholders several months ago in our article on Seeking Alpha entitled "Rite Aid - Vote 'Em Out On October 30th". We followed this article up with a blog post entitled "Rite Aid - Last Chance For Shareholders To Effect Change", which outlined additional problematic corporate governance and executive compensation issues requiring immediate corrective action by the company's leadership.

Disappointingly, all incumbent directors were re-elected at the annual meeting, meaning the company's shareholders will most likely suffer from suboptimal leadership at their company for the foreseeable future (as reflected in the current dismal stock price). Even worse, the company has utterly failed to follow up on its promises for further governance improvements. However, all is not (yet) lost, since we think that Rite Aid now stands primed for targeting by one or more activist hedge funds, which could benefit massively from a campaign to unseat the incumbent board and replace Rite Aid's failed management team. In this article, we provide the following: (1) an update on Rite Aid's corporate governance story, in light of promises made by the board of directors leading up to last year's annual meeting, (2) an explanation as to why the recently announced reversal split proposal is detrimental to Rite Aid shareholders and (3) specifics regarding why and how the company could become a prime target for an activist sooner rather than later (i.e., a "playbook for an activist" in Rite Aid).

Just the "First Steps" in Governance Reform at Rite Aid? Hardly

Back in September 2018, Rite Aid issued its proxy statement for the 2018 annual meeting. In the proxy, Rite Aid's board chairman-designee Bruce Bodaken and the other independent directors penned a letter addressed to the shareholders laying out why the company's board decided to appoint three new independent directors and strip CEO John Standley of his chairman's role, stating as follows:

Based on the feedback [from shareholders] we received, and consistent with our commitment to align Rite Aid's interests with those of our stockholders, we are making several changes to strengthen and enhance the Board's governance oversight. First, the Board has decided to separate the positions of Chairman and Chief Executive Officer, and Bruce G. Bodaken will hold the position of Chairman effective at the 2018 Annual Meeting of Stockholders. The Board also has significantly accelerated its efforts to change the composition of the Board. As part of that refreshment process, three of our current eight independent directors will not be standing for re-election and we are nominating three new independent directors-Robert E. Knowling, Jr., Louis P. Miramontes and Arun Nayar. These changes will bring fresh perspectives to the opportunities and challenges before us.... We are committed to continuing the Board refreshment process over the next year to ensure we have the right mix of experience, expertise and fresh perspectives to guide Rite Aid going forward.

Moreover, the letter from the Rite Aid directors made the following promises to the company's shareholders:

We view the governance changes described above as the first steps in reinvigorating our corporate governance practices and policies. Over the coming year, the Board will continue to seek stockholder input and identify new candidates to further refresh the Board. We will also consider [other] corporate governance enhancements, including addressing items specifically raised by stockholders in the course of our recent and ongoing engagement efforts.

Over four months have now elapsed since the date of the 2018 proxy statement, yet since then (and despite these promises), we have seen Rite Aid's board take precisely zero "additional steps" to further reform governance. In our original article, we asked aloud the following obvious questions raised by the directors' letter: 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 is the board waiting for? In other words, why hasn't Rite Aid taken such steps already? We re-iterate these questions today. Regardless of whether the promises were genuine or not when made, the "radio silence" emanating from Rite Aid ever since the 2018 annual meeting is deeply disturbing from the perspective of a shareholder.

Entrenchment and Excessive Executive Compensation Still The Norm

A. RAD's Board Continues To Remain Firmly Entrenched

Since the October 2018 annual meeting, Rite Aid's board of directors has taken additional steps that, in our view, prevent the true owners of the company, the shareholders, from effecting real change at Rite Aid (perhaps not coincidentally, the stock is down substantially since then). We note in particular the manner in which the 2019 annual meeting and a special meeting regarding a proposal to reverse split the stock were scheduled. First, after regular market hours on Friday, December 28, 2018, Rite Aid filed a form 8-K which stated that the company had amended its bylaws (eight days earlier, on December 20th) to provide that if Rite Aid's annual meeting of stockholders is more than 30 days before or more than 60 days after the anniversary date of the prior year's annual meeting, to be timely, proxy access nominations must be received by the Secretary at Rite Aid's principal executive offices not more than 165 days prior to the date of the annual meeting and not later than the later of (1) the 135th day prior to the date of the annual meeting or (2) the 10th day following public disclosure of the date of the annual meeting. Eleven days later, Rite Aid filed yet another Form 8-K specifying that the 2019 annual meeting would be held on July 19, 2019 (more than three months prior to the anniversary date of the 2018 meeting, which occurred on October 30, 2018), and thus the following rules would apply regarding nominations and shareholder proposals for the 2019 meeting:

As a result [of the advanced scheduling in the calendar of the 2019 meeting vis-a-vis the 2018 meeting], the deadlines for stockholders to submit proposals and nominations of directors as set forth in Rite Aid's definitive proxy statement for the Company's 2018 annual meeting of stockholders are no longer effective.

Under the Company's amended and restated By-Laws (as so amended and restated, the "By-Laws"), in order for stockholder proposals and director nominations to be presented at the 2019 Annual Meeting (other than by means of inclusion of a stockholder proposal in the proxy materials under Rule 14a-8 and proxy access nominations, which are each described below), the Company must have received proper notice at the Company's principal executive offices not later than the close of business on January 18, 2019....

Under the Company's By-Laws, in order for proxy access nominations to be included in the Company's proxy materials and presented at the 2019 Annual Meeting, the Company must have received proper notice at the Company's principal executive offices not before February 2, 2019 and not later than the close of business on March 4, 2019....

Stockholder proposals intended for inclusion in the Company's definitive proxy statement for the 2019 Annual Meeting pursuant to Rule 14a-8 under the Securities Exchange Act of 1934, as amended, must be received at Rite Aid's principal executive offices no later than February 8, 2019 (which the Company believes is a reasonable time before it begins to print and send its proxy materials).

Now, let's compare these deadlines to those included in the 2018 proxy statement (on page 74):

  1. Shareholder proposals (other than Rule 14a-8 proposals) were originally supposed to be submitted by May 30th (rather than January 18th);
  2. Rule 14a-8 proposals were originally supposed to be submitted by August 1st (rather than February 8th); and
  3. Director nominations were originally supposed to be submitted no earlier than April 30, 2019, and no later than May 30, 2019 (rather than January 18th for regular nominations or, for proxy access nominations, between February 2nd and March 4th).

Thus, we find that by moving the 2019 up in the calendar by more than 30 days versus the prior year, key shareholder deadlines for the annual meeting were set much earlier in the year than would otherwise be the case (including advancing the Rule 14a-8 deadline by nearly five months!), the practical effect of which is to reduce the possibility that an activist might take a major stake in the company, or that a regular shareholder might wish to submit a proposal to be included in the proxy statement, prior to such deadlines, in each case in order to effect desperately needed reform and/or regime change at the company.

Next, we note that on January 4, 2019, the company filed a Form 8-K stating that Rite Aid was out of compliance with NYSE listing requirements, due to the stock price falling below $1 for 30 consecutive trading days. Rite Aid stated in the 8-K that "[i]n accordance with the NYSE's rules, Rite Aid has six months from the receipt of the notice [on January 3rd] to regain compliance with the NYSE's price condition or until the company's next annual meeting of stockholders if stockholder approval is required, as would be the case to effectuate a reverse stock split, to cure the share price non-compliance". This was followed on January 25, 2019, by the announcement of a special meeting on March 21, 2019, to reverse split the stock in order to regain compliance with the listing rules (see the proxy statement for the reverse split here).

The timing of the reverse split special meeting is curious indeed, especially if one naturally distrusts the motives of Rite Aid's board (as we do, in light of recent history). For starters, note that an NYSE-listed company can appeal a delisting decision under Section 804 of the NYSE's Listing Rules, thereby possibly extending the 6-month cure period. Pier 1 (PIR) noted this in their delisting press release from several weeks ago, stating that "Pier 1 has a period of six months from receipt of the notice to regain compliance with the NYSE's minimum share price requirement, with the possibility of extension at the discretion of the NYSE". So, why would Rite Aid go to the trouble and expense of scheduling a special meeting on the reverse split when they could have (1) simply moved the annual meeting date up a few weeks from July 19th in order to fall within the 6-month deadline or (2) if option #1 was not available for some reason, asked the NYSE for a short-term extension to July 19th, in either case, so that shareholders could vote on the reverse split at the already-scheduled annual meeting?

We note in this respect that the special meeting's record date is February 5, 2019, which is far in advance of the annual meeting's anticipated record date (which will likely fall near the end of May). This again restricts the ability of activists to get a toehold in the stock who might oppose the reverse split. Why might an activist want to block the reverse split? The answer is simple: index and other passive funds. Below is a snapshot of Rite Aid's largest institutional and mutual fund holders:

RAD institutional holdersRAD Mutual Fund Holders (source: Barron's)

As can be seen above, Rite Aid's largest shareholders are mostly comprised of passive index funds and ETFs run by entities such as Vanguard and BlackRock (the only known Rite Aid activist, Highfields, was significantly selling down its stake during Q3 of 2018 after closing its doors to outside investors). Passive funds are notorious for rubber-stamping management decisions and almost never voting against unopposed board slates at annual meetings. In effect, such funds are an entrenched and underperforming board and management's most loyal allies. For example, during fiscal 2018, in the United States, Vanguard voted in favor of (1) incumbent directors a staggering 95% of the time and (2) management-initiated governance proposals 90% of the time, yet supported shareholder-initiated governance proposals just 24% of the time, a shocking disparity (see page 35 of Vanguard's FY 2018 Investment Stewardship Annual Report).

If Rite Aid's shares were delisted from the NYSE, many passive funds would be forced by their own internal rules to divest from Rite Aid stock. For example, the prospectus of the Oppenheimer Global Opportunities Fund, the largest Rite Aid mutual fund holder (with ownership of 4.7% of the outstanding shares), states on page 13 that "the Fund will not invest more than 15% of its net assets in illiquid investments, [which are defined as] investments that do not have an active trading market, or that have legal or contractual limitations on their resale". Suffice it to say that any delisting would cause massive turnover in Rite Aid share ownership, potentially putting hundreds of millions of shares into new (activist?) hands, who we believe would likely be much less willing than the index funds and ETFs to blindly support Rite Aid's incumbent board and management. All the reverse split does is bail out Rite Aid's leadership from a problem of their own creation (a low stock price). If they want to keep passive, loyal (to board and management) shareholders in Rite Aid stock, they should earn this privilege by getting the stock price back up through financial and operational performance, not by simply reducing the number of shares outstanding. Incidentally, with Rite Aid shares down 17% since January 25th, the market has loudly broadcast its negative view of the reverse split proposal.

B. RAD's Board Continues To Reward Executive Management Failure

We also conclude that there is little desire on the part of Rite Aid's board for further governance reform by examining executive compensation practices at the company. Despite the fact that the annual advisory vote on executive compensation garnered the support of just 16.6% of the votes cast at the 2018 annual meeting (82 million out of 493 million), no announcements have been made regarding how Rite Aid's executive compensation will be amended going forward. In fact, in early January 2019, the board handed out over six million free shares of restricted stock to senior executives, indicating that "more of the same" failed compensation practices are still in effect:

RAD stock handout January 2019 (Source here)

At last count, CEO Standley had received in excess of $43 million in cash compensation since first entering the C-suite in late 1999 (including an utterly outrageous $3 million so-called "retention bonus" during 2018), despite the stock price falling over 90% from $8.25/share since then to the current level. Yet, the three Rite Aid compensation committee directors inexplicably deemed him worthy of receiving an additional 2.38 million shares of stock courtesy of the shareholders (who are diluted by such issuances) just a few weeks ago. In light of the massive shareholder repudiation of Rite Aid's compensation practices just three months ago, does such a "pay-for-failure" award make any sense at all?

Playbook For A Rite Aid Activist

The opportunity for an activist in Rite Aid is compelling for a simple fact: the stock is down over 90% from where it traded just over two years ago, meaning the equity is currently significantly undervalued versus peers. For example, Rite Aid stock trades far below Walgreens Boots Alliance (WBA) and CVS Health Corp. (CVS) on a forward price-to-sales basis:

Company FY2019E Sales Market Cap P/S Ratio
RAD 21,900 800 3.65%
WBA 137,410 67,815 49.35%
CVS 193,590 84,343 43.57%

(Source: Company SEC filings; Capital IQ metrics)

If Rite Aid traded comparably to WBA and CVS on a P/S metric, its stock price would be approximately $9.50/share (incidentally, slightly higher than the $9/share original buyout price agreed to between Rite Aid and Walgreens in October 2015).

Moreover, Rite Aid trails both WBA and CVS significantly with respect to its EBITDA generation capability, meaning there is much fat for an activist to trim in order to get Rite Aid more in line with peers (for starters, compensation should be brought way down for senior executives, as the company is now half the size it was prior to the Walgreens asset sale transaction):

Company FY2019E EBITDA EBITDA Margin
RAD 570 2.60%
WBA 7,875 5.73%
CVS 12,657 6.54%

(Source: Company SEC filings; Capital IQ metrics)

Below is our list of three "Must Do" Initial Action Items for any potential activist in Rite Aid:

1. Replace Rite Aid CEO Standley. Since a picture is worth 1,000 words, we have summarized the CEO's abysmal track record with a few selected graphics.

First, the stock price:

Standley Track Record(Source: Rite Aid press releases and SEC filings)

Note that, except for the brief period during 2014-2016 when investor hopes for the (ultimately failed) buyout of Rite Aid by Walgreens were aroused, Rite Aid's stock performance with Standley involved has been an unmitigated disaster for shareholders, including a decline of over 90% since Standley first entered the C-suite as CFO in late 1999. In fact, as of February 1, 2019, the stock has trailed the S&P 500 by the following staggering margins during the relevant time periods (without even considering the fact that the S&P has paid regular dividends throughout the entire period whereas Rite Aid has not paid a dime in dividends since Standley originally became a senior Rite Aid executive):

(1) 175% underperformance since December 1999 (+84% for the S&P versus -91% for Rite Aid) [Standley first enters C-suite];

(2) 165% underperformance since June 2008 (+113% for the S&P versus -52% for Rite Aid) [Standley returns to Rite Aid as an advisor];

(3) 173% underperformance since June 2010 (+145% for the S&P versus -28% for Rite Aid) [Standley named CEO]; and

(4) 140% underperformance since May 2012 (+98% for the S&P versus -42% for Rite Aid) [Standley named Chairman].

Next, the financials (amounts in $MM):

RAD Trailing Operating IncomeRAD AEBITDAPro Forma AEBITDA

(Source: Rite Aid SEC filings; Barron's)

From these charts, we see that Rite Aid under CEO Standley has failed under each relevant financial metric, including (1) pretax income over the past five fiscal years, (2) adjusted EBITDA over the past five fiscal years and (3) pro forma adjusted EBITDA (adjusted to reflect the Walgreen's asset divestiture) over the past four fiscal years. Finally, we note that over the past 5 fiscal years (i.e., FY 2014 through FY 2018) Rite Aid has spent $1.75 billion on capital expenditures and acquisitions over and above its aggregate depreciation, yet the current market cap is less than half of this amount, showing how disastrous capital allocation has been under Standley.

Yet, despite a veritable mountain of evidence that change is desperately needed in the CEO role, Rite Aid's independent directors in their letter included at the front of the 2018 proxy statement bizarrely claimed that "the Board firmly believes that John Standley is best situated to serve as Rite Aid's Chief Executive Officer". Come again? Clearly, if any senior executive has ever had a fair opportunity at a public company to try to create value for its shareholders (despite failure after failure to do so), it has been Rite Aid's CEO Standley. Over 19 years of failure does not inspire confidence that "the 20th year will be the charm" for this executive. The bottom line is that I firmly believe Standley needs to go ASAP and be replaced by a capable and thoughtful leader from outside the company. Only an outsider can avoid the "groupthink" that apparently afflicts the incumbent board and management and truly grapple with, and thereby tame, Rite Aid's operational underperformance and leadership entrenchment and unaccountability.

2. Replace All Three Compensation Committee Directors, Including Board Chairman Bodaken.

All three directors on Rite Aid's compensation committee, namely Board Chairman Bruce G. Bodaken, Marcy Syms and Michael N. Regan, have clearly failed in designing an effective senior executive compensation scheme at the company and must be replaced, once again by directors with no affiliation to the company (meaning no loyalty to the CEO). The fact that the advisory vote on executive compensation received just 16.6% support of the shareholders at the 2018 annual meeting is bad enough. The fact that literally nothing has been done since then to overhaul compensation practices at the company is absolutely inexcusable. These three directors simply are not doing their job and need to be replaced as soon as possible. Unless sanity is restored to Rite Aid's compensation practices and "pay for failure" is permanently eradicated, we believe the company will continue to fail and shareholders will continue to get poorer.

3. Designate As New Board Chairman A Representative Of A Significant Shareholder

In our view, one of the key reasons Rite Aid's governance has been abysmal in recent years is that the company's insiders have put virtually no skin of their own in the game (via open market stock acquisitions). As we noted in our first Rite Aid article, the last actual insider open market purchase of Rite Aid stock occurred in April 2015, when then-EVP Dedra Newman Castle bought a measly $2,243 worth of Rite Aid stock. Prior to this purchase, we can locate precisely ZERO insider purchases after mid-2008. If the directors and senior executives are not willing to put their own personal funds into Rite Aid stock, why should they expect anyone else to do so? Thus, we believe that it is absolutely essential that a new board chairman be appointed who is a representative of one of the company's large shareholders (and not from an index fund). This would truly align the board and the shareholders financially, meaning that the company would be much more likely to make rational decisions (from the perspective of the shareholders) regarding all of the issues outlined in this article. It is hard enough to compete and win in business as it is. However, it is virtually impossible when the financial incentives of insiders are not properly aligned with those of shareholders.

Conclusion

Since the October 2018 meeting, Rite Aid shareholders have been patiently waiting for the company to announce its promised further corporate governance reforms, yet none has been forthcoming. The latest machinations regarding the scheduling of the 2019 annual meeting and a special meeting to vote on a reverse split in the stock further confirm for any thinking shareholder that the company remains firmly in "entrenchment mode". Fortunately, this fact, combined with a cratered share price, presents an interesting opportunity for one or more activist shareholders to effect vitally needed change at the company (and, hence, make a large profit on Rite Aid stock from current prices). We believe that any such activist would be met by Rite Aid's long-suffering shareholders (other than the rubber-stamp passive funds) with open arms. We believe that if an activist were to simply implement just the three action items listed above (remove and replace the CEO, remove and replace the three compensation committee directors and appoint as new board chairman a representative of a major Rite Aid shareholder, preferably an activist), the stock would re-rate significantly higher.

This article was written by

Seven Corners Capital Management, LLC is an investment research and advisory firm based in New York City. The firm aims to achieve investment returns by identifying (1) companies with wide competitive moats and honest and able management, trading at reasonable valuations, (2) turnaround and "asset play" opportunities (as described by Peter Lynch in his book "One Up on Wall Street") and (3) special situations (such as mergers, spinoffs and liquidations) that provide attractive returns which are non-correlated to the broader equity markets. Our hope and expectation is to achieve annual returns approximately 10% above that of the S&P 500 on a long-term basis.

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.

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