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Rite Aid (NYSE:RAD), a leading pharmacy operator in the United States, has been in a tailspin over the better part of the past decade as operational headwinds and competitive pressures, coupled with a high brick and mortar operation caused sales and net income to decline.
The company was straddled with long term debt in a rising interest rate environment and has not put a significant turnaround plan in place until the past few years and while that has been slow to materialize, things are looking up for the battled pharmacy giant.
They managed to pay down a significant portion of their long term debt, reduce a sizable amount of their operating expenses, with more on the way, and are now focused on growing their organic business with online shipping of prescription being pivotal to their operations.
As a result of these measures and their current valuation, I think the company is worth a look for a potential long term investment. I previously held the company’s shares long for a few years, as you can read about here, and have enjoyed mixed success and eventually sold off the position at a more or less neutral return. I think it’s time for a new one. Here’s why.
Timeline It: First Steps
Back in 2015, Walgreens Boots Alliance (WBA) and Rite Aid announced a merger-acquisition which then faced intense regulatory scrutiny due to the monopolistic result as the United States would have essentially been left with just two major pharmacy chains – Walgreens and CVS (CVS).
The 2 companies nixed the plans after it was clear that the FTC (federal trade commission) would not approve the merger in 2017 and instead, Walgreens bough 2,186 stores from Rite Aid, which cut Rite Aid’s store footprint by half.
While Walgreens spent over $750 million rebranding those stores and subsequently closed over 600 of them, Rite Aid took in the almost $5 billion in cash and used it to rebrand their own stores, invest in their online and delivery apparatuses and of course – paid down a sizable portion of their debts.
Debt Reduction Helped Save Millions
The company held just shy of $7 billion in long term debt at the end of 2016, which caused their company leverage to be off the charts as they were beginning to lose organic sales and income, even accounting for the merger.
They used about $3 billion of the $4.4 billion in cash they got to pay down their long term debt and in 2017, after the store acquisitions closed, they reported just $3.2 billion in long term debt. This didn’t only deleverage the company but also was done at a pivotal point in the global economic cycle as interest rates were climbing then after the federal reserve began raising interest rates in the final quarter of 2015.
This has resulted in the company’s interest expense to remain relatively low, as the payment they were making went down from just shy of $400 million a year to just shy of $185 million a year. Even though for a company making over $20 billion in sales this may seem insignificant, it was anything but – the company was only generating around $400 million in operating income at the time, meaning the move saved them nearly all of that in cash that year and the next few as their operating income fell further.
Operational Efficiency – Work In Progress
With operating expenses (selling, general and administrative) lower after the sale of the 2,350 stores to Walgreens, the company has been struggling to make good and efficient work of lowering operating expenses since.
The company’s operating expenses fell from $6.7 billion to $4.8 billion after the sale of the stores to Walgreens but has since remained nearly flat through their most recent financial reporting at around $4.9 billion. They have a few tricks up their sleeves to try and move these figures down, even as revenues rise, and I believe this is where they can begin approaching a road to return to profitability over the next few years.
With the company reporting a net loss of about $500 million every year, a 10% reduction in operating expenses can put them on a solid road back to profitability and become a potentially excellent longer term investment.
Revamp & Refocus: The Road To Success
Right now, the company has been doing the traditional cost cutting measures like closing down some underperforming stores, reshuffling management teams to make sure they focus on their turnaround efforts and more. However, as they do those things, they are also investing quite heavily in transforming their existing stores into pharmacy hubs which can compete with CVS and Walgreens.
This means that for the past 2 years, as that turnaround phase has taken place, we haven’t seen any meaningful savings in their operating expenses. But what it does mean, I believe, is that we’re about to see those expenses come down by a significant amount while their strategic refocusing on their PBM (pharmacy benefits management) should drive solid revenue growth.
Driving Sales: Pharmacy Benefits Management
The company has worked to develop its own PBM (pharmacy benefits management) platform, called Elixir, in order to build a sustainable business of sales growth for the long run. This program includes benefits programs such as reward programs, Medicare-approved prescription drug plans, specialty pharmacy solutions, mail orders of prescription drugs and other discounted prescription drug plans and solutions.
By account of the CEO and some investment banking analysts, this program is the true value which the company and investors can unlock and has even been subject to renewed takeover speculation with a recent inquiry, which turned out to be a little iffy, by Spear Point Capital, which the company rejected.
The business has already shown investors that it’s working, as the company grew sales from around $22 billion when this initiative was first announced to around $24.5 billion, more than a 10% increase on the back of this initiative.
Driving Margins, In The Future
As the company continues to invest heavily and just start to reap the rewards of this new program and revamped stores and pharmacies with a focus on patients and their health and how they interact with the company’s over 6,000 pharmacists, they’ve been operating in a slightly less profitable environment.
But it’s not just about the past, it’s about the future. And that future, I believe, is bright as the company will begin showing much lower operating expenses after they’re done with revamping their pharmacies and stores as well as begin to take in slightly higher gross margins as they become more efficient with the Elixir program. This should happen, I believe, around the second half of 2023.
Most Recent Quarter: An Updated Look
While the headline numbers for the company’s most recent quarter look quite terrible, as you can read at more length by clicking here to read SA News Editor Dulan Lokuwithana, it was driven in large part due to the company’s impairment charges on their pharmacy segment as they shutter stores.
The guidance includes this as well, meaning that the company is likely to report lower margins for the coming few quarters as they continue with closing down underperforming stores and taking impairment charges.
While I believe that this is what is driving the short term price declines, it’s about the company setting themselves up for the future and in order to conserve cash in the future, they must take charges now with paying severance for workers in those closed stores and everything else related to closing a store like real estate losses, lease losses and the likes. While these factors may increase the short term headwinds the company’s margin will face, I still believe they’re better positioning themselves for the future.
Valuation & Investment Conclusion
When it comes to assessing what potential return the company has, we can look no further than the company’s own peers and their sales multiples. Since we don’t know when the company may return to profitability or what that will look like, it is, I believe, a better way to assess the company’s fair value.
Right now, companies like Walgreens and CVS both trade at around 0.3x their forward sales projections for the coming year or two. Rite Aid trades at about 0.01x those same projections. While I don’t believe we can equate those two given the growth trajectories in the coming year or two, we can certainly put an ultimate fair value at around 0.1x to 0.15x forward sales once Rite Aid comes to a point where it’s generating meaningful sales growth on the back of its new Elixir pharmacy benefits management program.
As a result, I do believe that we can see the company’s fair value at around $1 billion over the next 3 years or so, which presents a near tripling of its current valuation, as its current market capitalization is around $335 million.
This means that there is a potential for a return of around 100% a year, which will easily outperform the company’s peers and the broader market.
As a result of these factors, I believe the risk to reward profile has shifted once again for Rite Aid and I am re-initiating a long-term position in the company through the purchase of shares. I will hold for 12 months as we await further information about the company’s operating expenses and sales growth.
I am bullish on Rite Aid’s long-term prospects.
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