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Rite Aid: Private Market Value – Seeking Alpha

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Bewildering

Anyone who spends any length of time exposed to securities markets will see things that can only leave them scratching their head.

Take the now aborted take-over of Rite Aid (RAD) by Walgreens Boots Alliance (WBA).

Rite Aid Logo

Back in October 2015, Walgreens agreed to acquire Rite Aid for $9.7 billion in an all-cash transaction. Walgreens’ offer was $9.00 per Rite Aid share with Walgreens valuing Rite Aid on a total enterprise value basis of $17.2 billion (with Walgreens assuming Rite Aid’s then net debt).

At the time that Walgreens made its offer, Rite Aid was trading at around $6.20 per share. Walgreens’ offer price thus represented a premium of around 48% to Ride Aid’s then closing price.

Fast forward to today. On June 29, 2017, Walgreens decided to terminate its merger agreement with Rite Aid and to replace it with a new agreement pursuant to which Walgreens will acquire 2,186 Rite Aid stores, three Rite Aid distribution centres and related inventory for $5.175 billion in cash, plus the assumption by Walgreens of related leases.

But there’s more.

In addition, Walgreens will give Rite Aid an option exercisable through to May 2019 to become a member of Walgreens’ group purchasing organization, effectively giving the much smaller Rite Aid post-sale some of the purchasing power of the much larger post-acquisition Walgreens.

The market response? Rite Aid’s share price promptly collapses by almost 44% – from around $3.93 on June 28 to $2.23 on 14 July 2017.

Maybe I’m easily impressed but I find that reaction remarkable.

Why? Because Walgreen’s initial offer to acquire Rite Aid as a whole enterprise and its revised offer to acquire just 2,186 Rite Aid stores plus Rite Aid’s three distribution centres are private market valuations by an informed buyer in the retail pharmaceutical business. Not only that, they are private market valuations of an informed buyer in the retail pharmaceutical business after it has reviewed Rite Aid’s books!

The only way the violent decline in Rite Aid’s share price makes sense is if Walgreen’s revised offer values Rite Aid at or below a 44% discount to Rite Aid’s closing price on June 28, 2017. But does it?

Private Market Value

Before I get to that, let me say a few things about private market value.

Of the several methodologies proven for valuing public companies that of private market value or PMV is high on my list.

The methodology is most closely associated with Mario Gabelli who defined PMV simply enough as “the value that an informed industrialist would pay to purchase assets with similar characteristics.” If you are looking to buy a house or car with particular characteristics, you are using PMV when you look at recent sales of cars or houses with the same or similar characteristics and use that as a guide to your buying.

Of course, more goes into the value of a large business than goes into homes or cars and the authors of Value Investing: From Graham to Buffett and Beyond thought fit to expand upon Gabelli’s definition by adding that:

The PMV contrasts with the value that the stock market is placing on the equity of the firm. In the market, the last trade determines the value. All the players who make up the market – Mr. Market, as we have called this collectivity – have an equal say in what that price should be. They trade shares back and forth, some motivated by their sense of what the company is worth, others by the prior movement of the stock price itself. Over the course of a day, a month, or a year, the price can move one way or another without any fundamental changes to the business of the company or even, on a larger scale, to the outlook for the economy as a whole. Certainly there are moments when the market price is a good reflection of the intrinsic value of the company, but if that were constantly true, the price would not fluctuate so dramatically. The industrial buyer, concerned with the worth of the business and the cash it can generate, has a less frantic disposition than the market and regards sharp declines in price as an opportunity, not as a cause for panic.

The concluding observation accords with Ben Graham’s maxim that investment “is most intelligent when it is most businesslike.” That is to say, investing is most intelligent when it most closely approximates the process that a private market buyer would follow when considering whether to make a private market purchase.

While Gabelli is rightly credited with bringing PMV into the mainstream among value investors, Warren Buffett in his letters to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders has regularly talked about buying equities using the same criteria that he uses when purchasing 100% of a business. Thus, as early as 1978, Buffett referred to buying equities which were “attractive when measured against the yardstick of value to a private owner” (emphasis added).

Now, of course, an intelligent use of PMV in forming a reliable valuation of the stock in public companies requires more than just a mechanical application of the price that Company A paid for Company B to the equity value of Company C.

At the same time, in the case of Walgreens’ initial offer for Rite Aid and its revised offer for just the 2,186 Rite Aid stores, the three Rite Aid distribution centres and related inventory, we are not breezily extrapolating the unique factors that may have justified Company A buying Company B at one price to the valuation of Company C.

We are dealing with a situation where Company A has told the market what it considers Company B to be worth on a full take-out basis and, as an alternative, what it considers 2,186 of Company B’s stores and 3 of its distribution centres and related inventory to be worth. And, if my mathematics is correct, the market appears to have thrown Walgreens’ valuation back in its face and said it is not worth the paper it’s written on.

This must be considered extraordinary because not only is Walgreens an informed buyer whose knowledge of the pharmaceutical retail business likely exceeds the collective knowledge of the market but Walgreens most certainly has the most up-to-date and in-depth knowledge of Rite Aid’s individual business than anyone currently buying or selling Rite Aid’s stock has. And yet the market has declared that Walgreens’ knowledge doesn’t count for squat.

What could possibly have brought about this state of affairs?

Trapped in Merger Arb

In my view, it is due to merger arb investors being trapped in a stock that they don’t want and needing to sell at any price.

The selling that occurred steadily before Walgreens’ revised offer and the accelerated selling that occurred through most of last week was forced selling. It was selling that was occurring without regard to the economic value of the thing being sold.

For a buyer in such circumstances, these moments are golden. Whether it’s a used car or a home, it pays immeasurably to know that the buyer selling the thing needs to sell in a hurry and to sell at any price. That is information worth paying for.

Even though an event-driven strategy like merger arbitrage is widely practised among professional money managers, there is not a great deal of sophistication to it. Investors rush out to buy the stock of the company to be acquired and profit from the spread lying between trading price of the stock and the offer price.

But many funds whose bread and butter is merger arbitrage also use leverage – and, when money can be borrowed at a few hundred basis points, often a lot of leverage – to increase returns. So, naturally, when these mergers don’t turn out as planned, as occurred in Walgreens’ initial take-over of Rite Aid, these funds stampede for the exits and that means dumping stock at any price on their way out.

How to Turn a Strength into a Weakness

Yet for investors to infer from that that the prices at which hordes of trapped merger arb managers are off-loading millions of dollars’ worth of stock is what “an informed industrialist would pay to purchase assets with similar characteristics” is crazy at any time. But it is certifiably insane when that “informed industrialist” has itself already offered to purchase the entire enterprise at a fixed price and remains willing to purchase over 47% of the company’s assets also at a fixed price that, by most measures, implies a valuation for the company that is double that which it is presently trading at.

Yet as Buffett said in his great 1984 paperThe Superinvestors of Graham-and-Doddsville” investors either get that value and price are distinct or they don’t. If they don’t, then jumping out of your positions and stampeding with forced sellers make perfect sense.

If you do get that value and price are distinct, then you are, in Seth Klarman’s words, “inoculated” against irrational market fluctuations and you stand to profit from folly rather than to participate in it.

Looking at Rite as a Private Market Buyer

So what might a private market buyer looking at Rite Aid see?

As the authors of Value Investing: From Graham to Buffett and Beyond noted, such a buyer is concerned first and foremost with “the worth of the business and the cash it can generate.” That is to say:

  • How much money will the business bring in?
  • What will my operating costs in the business be?
  • How much money will I need to reinvest to maintain my current level of operations?
  • Will there be any money left over to distribute to debtholders and owners or to grow the business?

Revenue

So how much money does Rite Aid bring in?

Judging from the recent performance of the share price, one would think Rite Aid’s revenue was under serious pressure when considered historically. Reality paints a slightly different picture:

2013

2014

2015

2016

2017

May 2016

Aug 2016

Nov 2016

Feb 2017

May 2017

25,392

25,526

26,528

30,737

32,845

8,184

8,030

8,090

8,541

7,781

Ok, so how much money will be left over after my operating costs?

Operating Income

2013

2014

2015

2016

2017

May 2016

Aug 2016

Nov 2016

Feb 2017

May 2017

647

721

881

813

532

101

131

114

191

-2

Rite Aid’s operating income showed growth until the end of fiscal 2016. Then it experienced a sharp decline 2017.

Operating Margin

But Rite Aid’s operating margins, while not unremarkable among retailers, are poor when compared to Walgreens’:

2013

2014

2015

2016

2017

May 2016

Aug 2016

Nov 2016

Feb 2017

May 2017

2.55

2.83

3.32

2.64

1.62

1.23

1.63

1.41

2.24

-0.03

For the last 5 years, Rite Aid has managed to generate on average only 0.0259 cents per dollar of revenue.

Walgreens’ Operating Margins

Consider, by contrast, Walgreens’ operating margins for the last 5 years:

2013

2014

2015

2016

TTM

5.67

5.49

4.51

5.11

4.78

Walgreens’ operating margins are on average well over double those of Rite Aid.

Now some might look at Rite Aid’s margins and despair. But at the time of its initial take-over offer for RAD, Walgreens almost certainly looked at Rite Aid’s much lower operating margins and saw an opportunity to more than double RAD’s operating profit. There is no reason to doubt that others looking at Rite Aid’s margins do not see the same opportunity.

A company’s operating margins also provide a window into management effectiveness. Rite Aid’s operating margins compared to those of Walgreens point to plenty of room for improved efficiency and sales gains in the business. They also highlight the need for changes at the executive level.

Capital Expenditure

What about the money that needs to be reinvested to maintain Rite Aid’s current level of operations?

2013

2014

2015

2016

2017

May 2016

Aug 2016

Nov 2016

Feb 2017

May 2017

-383

-421

-539

-670

-481

-122

-132

-128

-99

-69

Although Rite Aid is a larger business than it was 5 years ago, its capital expenditure was noticeably lower last fiscal year. That could suggest that Rite Aid has lately cut back on capital expenditures in the hope – now dashed – that it would be taken over by Walgreens. This expenditure cannot be put off forever and it will need to be made up in the near future.

Free Cash Flow

What about the amount of cash left over to pay down debt, to dividend-out to shareholders and/or for share buybacks or to grow by acquisitions and reinvestment in the business?

2013

2014

2015

2016

2017

May 2016

Aug 2016

Nov 2016

Feb 2017

May 2017

437

281

110

327

-255

38

-279

25

-38

24

Rite Aid’s free cash flow is nothing to write home about. It was generating modest free cash flow until 2017. Yet, there is likely no reason why it cannot do so in the future.

Again, if you were Walgreens or a knowledgeable private market buyer you likely see plenty of room for free cash flow to increase rather than a permanent cap placed on its growth. The same potential for meaningful improvements in the business lies in many of Rite Aid’s other financial metrics like net margins, interest expense and return on capital.

Walgreens’ Revised Offer

If the Federal Trade Commission allows Walgreens and Rite Aid to complete the revised deal, what will that mean for the value of Rite Aid’s equity?

Well, Walgreens has valued 2,186 of Rite Aid’s stores, 3 of its distribution centres and related inventory at $5.175 billion in cash. Acquisition of 2,186 of Rite Aid’s 4,621 stores reduces Rite Aid’s store count and, presumably, its reported inventory by 47.3%.

Let’s assign Walgreens’ $5.175 billion cash offer equally to Rite Aid’s 2,186 stores, its 3 distribution centres and to 47.3% of Rite Aid’s inventory as at the end of May 2017.

Rite Aid’s total inventory at the end of May 2017 was valued at $2.789 billion. Let’s assume that each of the 2,186 stores to be acquired by Walgreens has an equal proportion of inventory. Thus, $1.319 billion of Walgreens’ $5.175 offer price is for the inventory in Rite Aid’s 2,186 stores and 3 distribution centres. That means Walgreens is paying around $1.161 million per each acquired Rite Aid store and distribution centre.

That will leave Rite Aid with 2,435 remaining stores. If each store is worth $1.161 million, Rite Aid’s remaining stores with 52.7% of remaining inventory are collectively worth $4.296 billion.

Rite Aid has total debt as at the end of May 2017 of $7.178 billion. Including the $325 million break-fee payable to it, Rite Aid will receive $5.5 billion in cash. It has $200 million in cash on its balance sheet. That leaves Rite Aid with net debt of $1.478 billion. Whether Rite Aid applies the sale proceeds to the payment of debt does not matter at this stage.

RAD bought Envision Rx for $2 billion in 2015, which it is keeping, and it has 1.053 billion shares outstanding. There is no evidence that Envision Rx is worth less than Rite Aid paid for it (and considerable evidence that it is worth more).

In that case, RAD has an absolute rock bottom book value of around $4.8 billion or $4.57 a share. The stock closed on Friday, July 14, 2017, at $2.33 a share.

Conclusion

My own view is that Rite Aid’s shares are worth closer to $6.00 per share on a book value basis.

But the objective of the valuation above is not to establish to the fifth decimal place the value of Rite Aid’s equity, but to establish a floor of value beyond which Rite Aid’s share price shows up as either trading with a margin of safety or being too close to call.

Everyone recognizes the advantage they have when they know that they are negotiating with a seller for an asset that the seller is forced to sell.

It is a tremendous additional advantage to have information about a recent private market sale for exactly the same asset when dealing with such a seller.

The fact that none of this appears to have had any impact on the violent sell-off of Rite Aid over the last week should not come as any surprise.

If you are forced to sell a stock, you may know perfectly well that the price at which you’re selling makes no sense relative to the value of the stock. But that doesn’t matter. You don’t have the luxury of acting in accordance with that knowledge.

Nevertheless, the fact that many retail investors take this basic advantage and turn it into a disadvantage by allowing forced and uneconomic selling to guide their own investment decisions is a perennial mystery of stock market investing. It confirms Seth Klarman’s observation in the link above that investing occurs at the intersection of economics and psychology.

And it is the economics part of the equation that is the easier of the two to master.

Disclosure: I am/we are long RAD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Nothing in this publication is intended to be investment advice. Opinions expressed in this article are personal to the author and are not intended to constitute, and should not be read as constituting, any offer, invitation or recommendation to buy or sell any securities, whether they be securities referred to in this publication or otherwise.