Warren Buffett once stated that investors should "be fearful when others are greedy, and greedy when others are fearful." He wasn't talking about Rite Aid (NYSE: RAD) stock at the time, but does his advice apply to the embattled pharmacy retailer?
Plenty of people certainly seem to be fearful right now about Rite Aid stock. Shares have cratered in the wake of Walgreens Boots Alliance (NASDAQ: WBA) scuttling plans to buy the company. Instead, Walgreens wants to buy nearly half of Rite Aid's stores. Conventional wisdom says not to touch Rite Aid with a 10-foot pole (or even longer). But is this thinking wrong? Could buying Rite Aid stock now make you a big winner later?
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Sizing things up
In January, Rite Aid was valued at more than $8.5 billion. After Walgreens' decision to pull the plug on acquiring the company, Rite Aid's market cap now totals less than $2.4 billion.
As of now, Rite Aid owns 4,523 retail pharmacy stores. With roughly this number of stores, the company generated revenue of $32.8 billion and earnings of a little over $4 million last year. A big weight for Rite Aid was and is its debt of more than $7 billion. Because of this high level of debt, the company spent nearly $432 million last year just on paying interest.
Rite Aid's results from the first quarter of 2017 are even more depressing. Revenue fell nearly 5% year over year. The company posted a net loss of $75 million. Again, debt was a major issue: Rite Aid spent almost $110 million in the first quarter on interest payments.
If you're a pessimist, the valuation number for Rite Aid that will jump out is that the stock is trading at 45 times expected earnings. That's ridiculously high for a company with the problems Rite Aid has. If you're an optimist, you'll instead focus on the fact that Rite Aid shares trade at only 0.07 times sales.
Some probably wouldn't care about either statistic. They would likely simply look at Rite Aid's debt and bottom-line trajectory and conclude that the stock is toxic.
The "new" Rite Aid
But the Rite Aid of now might not be the Rite Aid of a year from now. The proposed Walgreens deal to buy 2,186 stores from Rite Aid changes the dynamics considerably.
The biggest positive for Rite Aid is that Walgreens has offered to pay nearly $5.2 billion in cash. Most of this amount could be used to retire debt. It's possible that Rite Aid could emerge from the transaction with a remaining debt load of around $2.5 billion. That would slash the company's ongoing interest expense considerably.
Of course, there's also a huge negative for Rite Aid. Assuming the deal with Walgreens is finalized, Rite Aid will be left with roughly 2,300 stores. Annual revenue would be significantly reduced -- probably to an annualized level of around $17 billion.
Terms of the agreement would allow Rite Aid to purchase prescription drugs through Walgreens Boots Alliance for a period of 10 years at costs similar to those that Walgreens pays. This is a nice plus for Rite Aid. On the other hand, the company would likely have less leverage in negotiating prices for all other products sold in its stores.
How buying Rite Aid could make sense
Let's do some quick back-of-the-envelope calculations. Take Rite Aid's 2016 financial results and slash all the numbers in half -- assuming that would be the approximate effect of selling the stores to Walgreens. The one number that wouldn't be halved, though, is interest expense. Instead, assume that this figure would be reduced by around 65% as a result of paying down debt with the cash received from Walgreens.
This quick calculation would generate earnings for Rite Aid of a little under $90 million. Using this level of earnings, Rite Aid stock is trading at around 26 times projected earnings with fewer stores and reduced debt. That's still high. But if you think the company can grow earnings over the next few years by double-digit percentages, Rite Aid stock doesn't look expensive at all. I doubt Rite Aid can achieve this level of growth, though.
However, look at the situation a little differently. If the proposed deal goes through, Rite Aid will have 2,300 stores valued at a little over $1 million per store based on the company's current market cap. Walgreens is paying nearly $2.4 million per store.
If you think there's a possibility that one or more other players would be willing to buy Rite Aid's remaining stores at even close to the level that Walgreens is paying, the stock is a tremendous bargain right now. This is something I'm sure a number of private equity firms are thinking about.
It's not inconceivable that one of these firms could pay a significant premium to Rite Aid's current price (but below what Walgreens is paying per store) to take the company private. The goal would probably be to eventually sell off the company in whole or in part at a price tag closer to the level that Walgreens is paying for Rite Aid's stores.
My hunch is that this second scenario is more likely to happen, and it will happen sometime in the next year or so. If so, buying Rite Aid stock now could make investors big winners in the not-too-distant future.
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