Please ensure Javascript is enabled for purposes of website accessibility

Here's Why the Worst Is Yet to Come for Rite Aid Corporation

By Cory Renauer - Oct 11, 2017 at 6:47AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Intrepid value investors attracted to Rite Aid's sinking stock price could be walking into a trap.

Rite Aid Corporation (RAD 1.63%) stock fell hard every time Walgreens Boots Alliance (WBA 1.74%) lowered its offer for the struggling pharmacy chain's retail outlets. Now that the deal is cleared for takeoff, intrepid value investors are being drawn toward what looks like a clear-cut opportunity. Based on Walgreens' final per-store offering price, Rite Aid's stores are worth several times more than the stock's recent market cap.

Although the arithmetic works out in theory, an uncooperative Federal Trade Commission and a rapidly deteriorating outlook for retail in general both limit the pool of potential suitors for Rite Aid's remaining stores. Without a buyer, there are reasons to believe a slimmed-down version of the company might become profitable. Upon closer inspection, though, it looks like the worst is yet to come.

Stack of paper money in a mousetrap

Image source: Getty Images.

Why the phone isn't ringing

There's an argument that even if Rite Aid can't squeeze out a profit with its remaining operations, another retail pharmacy chain will eventually scoop up its remaining stores. After paying $4.375 billion for 1,932 stores, Walgreens will leave Rite Aid with 2,575 locations.

At the same price of around $2.26 million per store, Rite Aid's remaining locations should be able to fetch about $5.8 billion. It might look like Rite Aid's market cap is less than half the theoretical value of its stores. Unfortunately U.S. antitrust regulators have made it clear that future retail-pharmacy acquisitions will be an uphill battle.

If uncooperative regulators don't scare suitors away, the ongoing retail apocalypse might. Pharmacies have fared better than department stores, but a recent report from IHL Group shows that drugstore sales during the first seven months of the year declined 0.9% from the same period last year, and closures exceeded openings.

Earlier this month, rumors surfaced that (AMZN 3.15%) is in discussions with mid-market pharmacy benefit managers, and has been hiring consultants to test the waters for its possible entry into the drug retailing market. Many analysts think the retail behemoth will begin filling prescriptions within a couple years. Whether these rumors rapidly materialize or not, the whispers alone are another strong deterrent to any potential acquirer of Rite Aid's remaining operations.

Downward-sloping chart that appears to be floating above an open palm

Image source: Getty Images.

A case of chronic decline

With little chance of another big asset sale, investors buying beaten-down Rite Aid stock need the company's remaining operations to become far more profitable. Unfortunately they've been trending in the opposite direction.

Rite Aid lost $21.1 million during the fiscal fourth quarter, and another $75.3 million during its fiscal first quarter this year. Although the company reported a $170.7 million profit during the most recent quarter, without the one-time $325 million merger termination fee from Walgreens, losses would have widened for the third straight quarter.

Pro forma metrics provided by management show the company will retain 2,575 stores that average $6.25 million in total sales, or about 8.7% more than the average store in its existing portfolio. A 10-year agreement that will allow the company to purchase generic drugs at lower prices, through a subsidiary of Walgreens, will help as well. Given the downward retail-sales trends reported by peers such as CVS Health (CVS 1.38%) and Fred's, though, a better mix of locations and the sourcing agreement probably won't be enough to return this company to sustainable profitability.

Failure to execute

Among Rite Aid's peers, CVS Health has been able to boost its bottom line at an impressive rate largely because it has successfully executed acquisitions of an enormous pharmacy benefits manager (PBM) in 2007, and long-term care operations in 2015. CVS reports intersegment revenue eliminations when PBM segment customers purchase their drugs at one of the company's pharmacies or long-term care centers. Intersegment revenue rose 7% in the first half of the year to $12.2 billion, which was a whopping 31.5% of total sales generated by the company's retail and long-term care operations.

Unlike CVS, Rite Aid doesn't operate long-term care centers it can supply with prescription drugs; the EnvisionRX PBM it scooped up a couple years ago is losing business and sending fewer customers into Rite Aid pharmacies. During the first half of Rite Aid's fiscal year, intersegment eliminations fell 9.6% lower than the previous-year period to just $81 million, which was a dismal 1.3% of retail pharmacy sales.

How Rite Aid won't spend a $4.38 billion windfall

Rite Aid's management intends to use nearly all proceeds from its purchase by Walgreens to reduce a crushing $7.1 billion debt load. While that should lower annual interest payments by more than $200 million, it's important to note the company won't be investing that money into operations that might improve its chance of survival.

Pharmacy benefit managers use their size to negotiate better prescription-drug prices for healthcare plan sponsors, but Rite Aid's PBM is small and getting smaller. Perhaps the company's new CEO can succeed where his predecessor failed. Without a steady stream of profits to invest, though, it's hard to see how this company will execute such a turnaround.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Rite Aid Corporation Stock Quote
Rite Aid Corporation
$6.85 (1.63%) $0.11, Inc. Stock Quote, Inc.
$109.56 (3.15%) $3.35
Walgreens Boots Alliance, Inc. Stock Quote
Walgreens Boots Alliance, Inc.
$38.56 (1.74%) $0.66
CVS Health Corporation Stock Quote
CVS Health Corporation
$93.94 (1.38%) $1.28

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 07/03/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.