Name That Trade – Totally $RAD All of a Sudden?

by Enis March 23, 2015 11:32 am • Commentary

Rite Aid seemed on the verge of imminent bankruptcy for a 10 year period from 2002 to 2012.  The stock traded in a range between $0.20 and $6.74 throughout that entire period.  More importantly, one visit to a Rite Aid store was often enough evidence to suggest that this company would not exist for long.

However, after more than a decade of failed turnarounds, the current management team seems to have finally generated some success at the beleaguered drug store chain.  RAD broke out to a new 10 year high about a year ago, and has threatened the $8.50 resistance level several times in the past 3 months:

RAD daily chart, 50 day ma in red, 200 day ma in blue, courtesy of LiveVolPro
RAD daily chart, 50 day ma in red, 200 day ma in blue, courtesy of LiveVolPro

Moreover, options activity has picked up substantially.  Open interest includes nearly 150k of the Apr17th 9 calls.  The stock’s next earnings date is scheduled for April 8th, and 30 day implied volatility is at a 1 year high, reflecting the significant call buying of the past month and the overall interest in the stock:

RAD 30 day implied volatility, courtesy of LiveVolPro
RAD 30 day implied volatility, courtesy of LiveVolPro

What has changed at Rite Aid over the past few years to generate renewed interest in this former loser?

First, CEO John Standley rejoined Rite Aid in late 2008, after successfully turning around Pathmark, a regional super-market chain based in New Jersey that was sold to A&P in 2007.  John Standley worked for Rite Aid starting in 1999 before leaving for Pathmark, and returned first as COO in late 2008, when Rite Aid was on the verge of bankruptcy, and has been CEO since 2010.

Most of John Standley’s main lieutenants on the current management team were also part of the Pathmark turnaround, including the Chief Operating Officer and the Chief Administrative Officer.  In other words, the management team is largely the same one that executed a turnaround in Pathmark stores from 2002 to 2007, which ended in a sale of the company.

In such turnaround situations, cash flow is key, and management has done a terrific job of both generating free operating cash flow and reducing the debt load.  The current situation is a stable business model with around $500-$700 million in operating free cash flow generated per year, with $200-$400 million in capex expenditures.  In that case, the equity looks quite attractive at around a $5 billion valuation (around 10x free cash flow, or $5-$5.50 per share in the stock), while it seems more fairly valued at current levels, depending on how the growth situation changes going forward.

On the downside, the debt load outstanding is still $6 billion, though all of that matures between 2018 and 2028, suggesting no significant liquidity issues even if we hit an economic downturn in the next couple of years.  So the financials look decent, and the stock’s near double since the mid-October low is a result of both a market paying up on valuations across the board as well as management’s expectation and communication to the market at the end of last year that 2015 is likely to be a continuation of recent positive trends.  Next month’s earnings report will be important for those assumptions.

Management’s long-term plan is to focus Rite Aid on health and wellness, becoming a major destination for drugs and wellness in its communities.  CVS and Walgreen’s are the behemoths in the sector, but Rite Aid has renovated nearly half of its 4,600 stores in the past few years as part of the turnaround plan, offering some competition for the first time in many years.  More than 1/3 of stores now have a Wellness Program, which offers advice and tracking for customers interested in improving their health.  Management has also introduced beauty advisors, vaccination tracking, and quit smoking programs in some of its stores, clearly looking to offer differentiated, improved customer service.

Finally, Rite Aid last month purchased pharmacy benefit manager EnvisionRx for around $2 billion.  That deal could offer Rite Aid customers better deals on drug prescriptions and also lower Rite Aid’s own procurement costs.

Add it all up, and the turnaround story looks sustainable for RAD, rather than just a function of a favorable economy and market backdrop.  So what about trades? With the very high level of implied volatility, long premium strategies in the stock don’t make a lot of sense, but a longer-term strategy, such as selling the August 7 put to buy the August 9 / 11 call spread for a small credit could be one way to get long exposure for those unwilling to buy the stock here but comfortable owning it below $7 given the fundamental situation.