A New Dawn at Rite Aid? Part 2 of 3
In our prior Rite Aid Corporation (RAD) blog post [for which, see here], we examined the recent changes to the company's board of directors and senior executive leadership. In a subsequent post, we will lay out a blueprint for these folks to follow to achieve Rite Aid 2.0 (success over the long haul). In this post, however, we will examine RAD's recent Q2 FY2020 earnings report, the current state of the company's finances and operations and how a turnaround scenario might look for RAD investors.
Q2 FY 2020 EARNINGS RELEASE
On September 26th, RAD issued its earnings press release for the second quarter of its fiscal year 2020, along with its earnings slides. First, the headlines:
While the growth in same-store prescriptions is encouraging, the company is still cash flow negative and mired in red ink, losing $79 million in the quarter on a GAAP basis and racking up negative $358 million of cash flow (although, in fairness, all of this negative cash flow came from working capital changes rather than from operations). These outflows were offset by $375 million of revolver borrowings. Here is the statement of cash flows for the first half of FY 2020, evidencing that RAD's financial performance has not materially improved from the prior year (an optimist might note that it hasn't gotten worse either):
Below are RAD's leverage calculations, evidencing an unsustainable net debt to AEBITDA ratio of 6.84X:
Note that, if we measured the leverage ratio on Q2's run rate basis and used EBITDA instead of "adjusted" EBITDA, this metric would have been far worse, at 8.8X [source: SCC calculations].
RAD is currently stuck in a negative feedback loop, owing to its $3.9 billion of debt and overall poor operating performance. Servicing the debt costs ~$240 million per year, which in turn means the company cannot generate positive free cash flow, which means it also cannot pay down the debt. Just over two years ago, former CEO Standley orchestrated the sale of about half of RAD's stores to Walgreen's for $5.175 billion. At the time, the former CEO claimed that "[t]he 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" (emphasis added). At the time, RAD's leverage ratio stood at 6.80X (see slide 20 here). Two years later we find that, despite the former CEO's optimistic assertions, RAD's leverage ratio in fact remains just about the same following the asset sale as prior to it--in other words, no deleveraging progress has been achieved (mainly due to continued declining EBITDA). Despite receiving approximately $4.4 billion in proceeds from Walgreen's in a tax-free transaction, RAD's net debt has been reduced only $3.5 billion (from $7.1 billion as of June 3, 2017 to $3.6 billion as of August 31, 2019), resulting in $900 million of "leakage".
On the positive side, the aforementioned bad news is now mostly priced in to the stock, which is down 86% since the WBA asset sale was announced in mid-2017:
In addition, RAD's operations do appear to be stabilizing around the current (low) level, evidenced by the following trends:
MODELING OUT A RITE AID COMEBACK SCENARIO
The prescription sales side of RAD's business is experiencing a bit of a resurgence over the past 10 quarters (all evidencing year-over-year growth), which is important since this segment accounts for almost half of RAD's overall revenues (48%, to be precise; front end sales constitute 24% and EnvisionRx accounts for 28% of aggregate revenues). If the Rx side of the ledger can continue to rebound, logically revenues and EBITDA should increase over time, especially if the PBM business, EnvisionRx, can fulfill its potential under new leader Ben Bulkley. Here is a comparison of the trends over the past 4.5 years (18 quarters) showing the correlation between Rx Sales (YoY quarterly %age change) and EBITDA (YoY quarterly %age change)--in both charts the low point appears to have occurred in Q1 of FY 2018:
If the recent Rx sales and EBITDA uptrend continues, how might a bullish scenario play out in terms of future financial metrics? We present one below:
In the above turnaround scenario, we assume a 3% annual increase in shares outstanding due to stock compensation grants (i.e., insider dilution) and that YoY EBITDA grow on the upside (during 2021-2023, positive 20-25%) is a bit less robust than it was on the downside (2017-2018, negative 25-30%). Importantly, however, given how levered RAD's stock price is to EBITDA, if we assume RAD's enterprise value remains constant at 7.5X EBITDA, this would imply a stock price of over $50/share by early 2023 (~6X the current share price), representing a CAGR of 68%. Not too shabby...ASSUMING the bullish scenario actually plays out as modeled above (a major assumption). In addition, by the end of FY 2023 in our model, due mainly to the growth in TTM EBITDA over time, the leverage ratio finally falls below 4X in early 2023 (all FCF assumed to be used to pay down down), allowing the debt to be refinanced on reasonable terms. Of course, this is a bit of a rosy scenario in light of the recent relentless downtrend in RAD's EBITDA, however we think it possible if (A) reimbursement rate pressures are ameliorated (the current governmental deadlock will help in this respect) and (B) RAD's new leadership takes emphatic measures to materially reduce RAD's bloated cost structure while revitalizing underlying operations with an entrepreneurial ethos which was sorely lacking (to put it mildly) under the Standley regime.
RAD's current financial state is quite precarious, due to its significant debt level combined with negative cash flows--6.8X leverage is not sustainable over the long run. On the positive side, we find that comparable pharmacy revenues and script counts have been growing recently, which is important given that nearly half of RAD's revenues are from prescriptions. Given the aging of the Boomer generation, these positive trends seem likely continue over the next few years and drive increased demand for prescription medication (by 2024 all of the Boomers, who currently number over 76 million individuals in the United States, will be in their 60s and 70s). Under the rebound scenario above, we think that RAD's stock price could climb back to $50+ per share over the next four years, up massively from the current ~$8 level. While this might seem incredible, it would actually only be a return to the $2.50 per share range on a split-adjusted basis (RAD performed a 1-for-20 reverse stock split earlier this year). The proof will be in the pudding, at least with respect to those areas under RAD's management's control: i.e., expense management (there appears much fat at RAD to be trimmed), crisp execution of the business plan and effective communication of the rebound story to investors. We will have more to share on these three topics in our final "Rite Aid 2.0" post...to be continued.
DISCLOSURE: Long RAD.