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What Rite Aid Will Do Now to Survive

Rite Aid (NYSE: RAD) and Walgreens Boots Alliance (NASDAQ: WBA) have scuttled plans to merge, and instead, Rite Aid will sell over 2,100 stores to Walgreens Boots Alliance for $5.2 billion in cash. The deal makes Rite Aid a lot smaller, but it could also make the company more profitable. Here's how Rite Aid plans on surviving as a stand-alone company. 

Details of the deal

Initially Walgreens Boots Alliance was going to pay $9.4 billion to buy Rite Aid, but the Federal Trade Commission (FTC) objected to combining these two large pharmacy players, so the deal was renegotiated to include the sale of 1,200 stores to Fred's Inc. (NASDAQ: FRED). As a result, the purchase price dropped to between $6.84 billion and $7.37 billion, depending on the final number of stores sold to Fred's.

Image source: Getty Images.

Unfortunately, that still wasn't enough to convince the FTC to OK the combination, so the merger has now officially been called off.

Instead, Walgreens Boots Alliance has agreed to acquire 2,186 Rite Aid stores and three distribution centers for $5.175 billion in cash. After certain expenses, Rite Aid expects to pocket between $4.5 billion and $4.7 billion in net proceeds. Walgreens Boots Alliance is also paying Rite Aid a deal break-up fee of $325 million.

Plans to survive on its own

Pharmacy retail is highly competitive, and the industry is dominated by CVS Health (NYSE: CVS) and Walgreens Boots Alliance. According to Drug Channels, CVS Health's U.S. prescription revenue market share was 14.8% and Walgreens Boots Alliance's market share was 13.8% last year. Their size gives them distinct advantages over Rite Aid, which has market share of 4.8%.

Although Rite Aid's market share will get smaller after it sells stores to Walgreens Boots Alliance, management believes it's going to be a lot healthier financially, and that will allow it to compete more effectively. 

The ability to reduce its debt is a big reason behind that optimism. It hasn't specifically outlined what debt it will pay off first, but it has indicated that its senior debt would be the first to go. Rite Aid's debt totaled $7.3 billion as of March.

Image source: Rite Aid.

Management expects paying down debt will cut its leverage ratio in half, and that it will significantly lower its interest expense and improve free cash flow. The company spent $432 million on interest expense last fiscal year, so the savings tied to paying down debt could be big.

A shift in its revenue mix and the potential to piggy-back on Walgreens Boots Alliance's purchasing power will also improve profitability.

Once its stores are sold, Rite Aid will get a much larger share of its revenue from its more profitable pharmacy benefit manager (PBM) segment, EnvisionRx. PBM revenue and EBITDA were $1.5 billion and $48.6 million last quarter, respectively, while retail store sales and EBITDA were $6.35 billion and $144 million, respectively. As a percentage of sales, EBITDA was 3.2% for its PBM business and 2.3% for its retail store business.

The PBM business will likely remain more profitable than Rite Aid's stores, but there is room for improvement there, too. As part of their deal, Rite Aid has the option to purchase products at equivalent prices to Walgreens Boots Alliance. Since Walgreens Boots Alliance is a much bigger company, leveraging its pricing power might offset the drag lower reimbursement rates are currently having on Rite Aid's in-store pharmacy profits.

Rite Aid's improved profitability should also allow it to refocus on remodels. Historically, stores its converted to its Wellness format have been better performers, and exiting this deal, 60% of its stores will operate under that format. Remodeling additional stores, kick-starting its in-store Redi-Clinic business, and investing in new ways to improve customer retention, such as expanded delivery, could all boost sales and earnings over time.

What's next?

Rite Aid has a lot of catching up to do, but it appears management is less focused on retail store count than it is on profitability, and in my mind, that's a good thing. If it can execute on its strategy, it could see earnings per share reaccelerate from recent lows, and as a result, its shares could head higher. Of course, for any of this to happen, the FTC will have to approve this latest deal, and unfortunately, that's not guaranteed. For this reason, investors will want to keep close tabs on regulators over the coming months for clues as to whether or not they'll greenlight this agreement.

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Todd Campbell has no position in any stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.