In March 2013, many analysts believed that RAD was too levered (it was) and the equity value was impaired. Back of the envelope calculations valued RAD at 8.3x through the equity on 900mm EBITDA, $6.2bn of debt, $200mm cash, and $1.5bn equity value ($1.60 stock price) which is expensive for a declining business. However, RAD had a few recent positive developments.

In late 2012 and in early 2013, Rite Aid (RAD) was able to extend debt maturities and reduct interest payments[1]. Before the transactions, RAD had $1.89bn of maturities through 2015, $2.7bn through 2016, and over $4bn through 2017. After the transaction RAD had only $1.3bn through 2017 and only $2.3bn through 2019 - almost 8 years of potential runway. Additionally, RAD had reduced interest payments by almost $100mm/year and total debt was reduced from $6.24BN to $5.99BN. See debt profiles below:

rad-credit

2012 RAD 2012 Maturity Profile

2012-post RAD Maturity Profile Post Debt Extensions

RAD had a few additional positives:

  • The U.S. economy was showing signs of strength and consumers were starting to spend more. RAD was very levered and the equity was very sensitive to operational improvements, margin expansion, etc.

  • Same Store Sales - SSS increased 2.0% in the year ending March 3rd, 2012 and was only down slightly over the course of 2012. Prescription counts were up almost 3%. SSS had been declining for years and stores were comping against low/trough numbers, but positive and improving SSS were still a good sign.
  • NOLs

At March 2, 2013, the Company had federal net operating loss (NOL) carryforwards of approximately $3,799,118, the majority of which will expire, if not utilized, between fiscal 2019 and 2022. the Company had state NOL carryforwards of approximately $5,015,041, the majority of which will expire between fiscal 2018 and 2026. [2]

RAD equity was being valued as an option. However, the equity did not rally after the debt extension announcements, and in fact, the stock actually declined. I felt the increased time value should have made RAD equity worth much more. An extremely levered RAD equity would have 8 years for any positive scenario to play out which could increase the equity value by multiples: improved U.S. recovery, improved margins, continued debt reduction, improving SSS, etc.

One of the most important inputs to the Black-Scholes (BS) option formula is time. RAD had just lengthened its runway by almost 6 years. While BS is not a linear equation, even being conservative and using 50% vol and increasing time from 2years to 4years, an ATM call is worth roughly 50% more. There is an argument that vol. should be much higher for a levered equity such as RAD, as the potential outcome distribution is very skewed. Using BS with a 2year time increase and vol 3x greater (50% to 150%) results in over a 200% increase in option value.

In the end, the increased runway and reduced interest payments finally allowed RAD management to invest in the business. RAD equity was very levered to the U.S. recovery and RAD equity increased substantially over the next few years:

rad-equity

[1] https://www.sec.gov/Archives/edgar/data/84129/000110465913012765/a13-5688_18k.htm

[2] https://www.sec.gov/Archives/edgar/data/84129/000104746913004721/a2214454z10-k.htm