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Why Rite Aid Corporation (RAD) Stock Has More Room to Run

Ian Bezek

One of Wall Street’s oldest sayings is that one should never try to catch a falling knife. That sentiment applied perfectly to Rite Aid Corporation (NYSE:RAD) all year. RAD stock has only known one direction: straight down. In fact, the stock has slumped from $8 to as low as $2.21 so far in 2017.

Why Rite Aid Corporation (RAD) Stock Has More Room to Run

Source: Mike Mozart via Flickr

However, the times appear to be changing.

Rite Aid stock hit its lows in early July, following the revised purchase agreement with Walgreens Boot Alliance (NASDAQ:WBA). Since then, almost two months have passed, and the stock’s bottom around $2.20 has held up.

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In recent trading sessions, RAD stock has even started advancing, gaining almost 10% since I suggested that investors shouldn’t give up on Rite Aid.

RAD Stock: “Powder Keg” of Short Covering

My colleague Joseph Hargett suggests that RAD stock will soon explode to the upside. As Hargett notes, short interest in RAD stock is elevated. It currently runs above 10% of the float. And contrary to what you might expect, speculators have upped their bets against Rite Aid stock as it has slumped, rather than taking profits. So far, short sellers have looked right, but things can swing in a hurry.

It’s always a tenuous proposition to short sell sub-$5 stocks. Margin requirements are elevated, borrow availability for short sales can dry up in a hurry and the risk/reward is lopsided. A stock can only fall to zero, whereas a $2 name can easily double or triple with some positive earnings momentum or an unexpected buyout offer.

Don’t Bank on a Buyout for Rite Aid

One of the catalysts that RAD stock owners point to is a potential buyout. I’m not sold on this outcome, however. Analysts often point to Amazon.com, Inc. (NASDAQ:AMZN) as a logical buyer. It’s true that Amazon has expressed interest in entering pharmacy. However, I’m not sure Rite Aid’s remaining store base is large enough to serve as an emphatic entry into the industry for Amazon.

Amazon did just buy Whole Foods Market, suggesting that it is eager to play ball in physical retail. However, it will probably be tied up for quite awhile implementing that acquisition.

Additionally, while Whole Foods has attractive high-end store locations and an upper-class customer base, RAD doesn’t bring such desirability to a prospective buyer. It’s also uncertain if Amazon wants the hassle of running a pharmacy benefit manager “PBM” such as Rite Aid’s EnvisionRX.

Beyond Amazon, it’s less clear who would buy Rite Aid. Obviously Walgreens is out, the Federal Trade Commission has made that clear over the past 18 months. The other large American pharmacy chain, CVS Health Corp (NYSE:CVS), would likely face a similar fate if it made a bid. Sure, private equity could take a run at the rest of RAD’s stores, but I wouldn’t pin my long thesis just on that hope.

What’s EnvisionRX Worth?

Two years ago, Rite Aid purchased its EnvisionRX PBM business for $1.8 billion plus a modest amount of stock. The total consideration was $2.1 billion, though it looks cheaper now since RAD stock has lost most of its value since then.

At the time of the purchase, EnvisionRX earned $4.3 billion in annual revenues. Since then, Rite Aid has grown the business almost 50% to $6.4 billion in revenues. If EnvisionRX is still worth 0.5x sales; the same ratio RAD paid for it, then EnvisionRX would be worth more than $3 billion today. By comparison, Rite Aid’s market cap is just $2.5 billion, and its post-Walgreens deal enterprise value would be about $4.8 billion.

Thus, EnvisionRX would support almost two-thirds of Rite Aid’s enterprise value. And based on the price Walgreens is paying for the Rite Aid stores it is buying, the rest of the stores would be worth about $5 billion, give or take a few hundred million. Add it all up, and RAD stock would be worth between $4 and $5. That’s some nice upside from today’s levels.

Now bears will claim that PBMs have lost value since 2015. It’s true that the industry is struggling. Leader Express Scripts Holding Company (NASDAQ:ESRX) has fallen from $90 in early 2016 to just $62 today. Profit margins across the industry have slumped as competition heats up. Against this backdrop, EnvisionRX might not earn a higher valuation than Rite Aid paid for it in 2015. But given the 50% growth in two years, its valuation probably hasn’t dropped either. Consider this the key asset that could spark serious upside in RAD stock if management figures out how to monetize it properly.

Rite Aid Stock: The Road Ahead

The first big step for RAD stock is closing the revised Walgreens deal. It still needs Federal Trade Commission approval, and it seems that some bears suspect this could be problematic. However this seems unlikely given the substantially smaller scope of the revised deal.

Once the store sale closes, Rite Aid will be infused with a huge amount of cash. Presumably, it will use this immediately to pay down high-interest debt that has burdened the company for years now. On an EBITDA basis, RAD stock has looked, and continues to seem healthy. However, interest costs on the company’s gigantic $7 billion debtload have largely consumed any cash the business generated.

Post-Walgreens deal, almost two-thirds of that debt disappears. On top of that, Rite Aid management can get back to focusing on improving its stores’ performance. This area has been lacking in recent quarters, presumably since managers were busy with merger-related business. Also, with a sharply reduced retail business, the company’s EnvisionRX division will be increasingly important and potentially be able to drive substantial upside for RAD stock.

The most obvious mover for Rite Aid stock in the near-term would be a short squeeze. The bears are out in force here, but they’ll probably want to move on once it is clear that the stock is no longer dropping. That could well power RAD stock back to the $3-level. Beyond there though, investors will need to be patient.

The situation is improving for Rite Aid, but it will take a couple of quarters for the reduced debtload to start making a big impact on the company’s profitability.

At the time of this writing, Ian Bezek held WBA stock. He had no positions in any of the other aforementioned securities. You can reach him om Twitter at @irbezek.

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