Rite Aid Corporation's (NYSE:RAD) stock dropped by 26.4% Thursday and even more on Friday after its merger agreement with Walgreens Boots Alliance (NASDAQ:WBA) disintegrated due to concerns that the deal wouldn't get past U.S. regulators. As a consolation prize, Walgreens did agree to purchase 2,186 Rite Aid stores for approximately $5.175 billion. And this new asset purchase agreement also allows Rite Aid to buy generic drugs sourced through Walgreens at cost for a period of 10 years. So, it's not all bad news for the struggling drug store chain.
As such, I think it's worthwhile to consider if the market overreacted to this news, or if Rite Aid's stock could head even lower now that a buyout is off the table. Let's take a look.
Rite Aid's two biggest problems may form a synergistic value-destroying force
With the ongoing pricing pressures from third-party payers and the U.S. Food and Drug Administration openly attempting to get drugmakers to pursue generic versions of high-priced branded medicines that have lost patent protection, drug store chains are facing some serious headwinds at the moment. Branded medicines, after all, bring in the high-dollar sales critical to growth -- even though generic medicines, on balance, rake in higher profits.
CVS Health Corp. (NYSE:CVS) and Walgreens -- the no. 1 and no. 2 largest national drug store chains -- are dealing with these headwinds by virtue of their sheer size. Long story short, CVS and Walgreens have far more bargaining power with third-party payers than a Rite Aid that's a fraction of their size. Moreover, CVS and Walgreens aren't exactly immune to the generic drug issue, but again, their size at least partially offsets this headwind, given their enormous sales volumes across the board.
Unfortunately, Rite Aid cannot afford to scale up due to its second biggest problem: debt. Before this asset swap, Rite Aid sported a jaw-dropping debt to equity ratio of 1,193%. While Mizuho Securities has Rite Aid's debt levels dropping by 75% following this deal with Walgreens, the company will still end up carrying an awful lot of debt for its size (approximately $1.9 billion under a best case scenario), and it'll lose roughly half of its revenue stream, if this deal goes through as planned.
Is Rite Aid a bargain or is the end nigh?
Rite Aid arguably dodged a huge bullet by getting Walgreens to buy around half of its stores. If the drug store chain walked away with nothing, the company would probably face big challenges in servicing its debt obligations based on its shrinking top line and minimal free cash flows. But that doesn't mean that Rite Aid is out of the woods just yet. At the end of the day, Rite Aid needs to scale up its business for the reasons outlined above, but it simply can't because of its sky-high debt load.
The bottom line is that Rite Aid is entering a period where it's probably going to be most attractive to private equity firms looking to purchase bits and pieces of the company on the cheap. And that's not a particularly attractive outlook for retail investors. Of course, another merger with an even smaller regional chain of drug stores might materialize and change this outlook. But any deal would also need to pass muster with U.S. regulators that seem to favor the status quo right now.
All in all, Rite Aid is wading in some deep waters, implying that this stock is probably only suited for individuals with a strong appetite for risk.