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Fitch Affirms Rite Aid Corporation at 'B'; Outlook Stable
October 27, 2017 / 1:21 PM / 24 days ago

Fitch Affirms Rite Aid Corporation at 'B'; Outlook Stable

(The following statement was released by the rating agency) NEW YORK, October 27 (Fitch) Fitch Ratings has affirmed Rite Aid Corporation's Long-Term Issuer Default Rating (IDR) at 'B' and removed it from Rating Watch Negative. The Rating Outlook is Stable. A full list of ratings follows at the end of this release. Rite Aid's rating incorporates its recently weakening drug retail results and concerns regarding the company's ability to stabilize pro forma EBITDA declines following the sale of 1,932 stores (43%, mostly in the Eastern part of the U.S.) and three distribution centers to Walgreens Boots Alliance for $4.375 billion, or around 16x TTM EBITDA. Declining operating results, including average pharmacy comparable store sales (comps) declines of around 4.5% over the past five quarters, have led to expectations of limited FCF generation and high adjusted leverage of around 7x even following over $4 billion of debt paydown using sale proceeds. Prior to the impact of the Walgreens transaction, Rite Aid's EBITDA is expected to decline to around $850 million in 2017 compared to $1.1 billion and $1.4 billion in 2016 and 2015, respectively, on low single-digit comps decline, similar to the 2.2% decline in 2016. Following the completion of the Walgreens transaction, pro forma EBITDA is estimated to be in the $550 million-$600 million range, including around a $215 million contribution from EnvisionRx and the remainder from Rite Aid's stores. EBITDA could decline modestly beginning 2018 unless Rite Aid can reverse recent retail comps trends. The rating also considers the enterprise's pro forma healthy liquidity and strong asset base that supports its capital structure, given ample value in the company's receivables, inventory and prescription files and healthy EnvisionRx pharmacy benefit manager (PBM) business even if retail operating results continue to decline. The valuation and recovery prospects are also supported by healthy trading multiples for drugstores relative to more challenged retail categories, as demonstrated by the substantial multiple Walgreens is paying for Rite Aid stores, and the 11.5x EBITDA multiple Walgreens originally offered in its proposal to buy Rite Aid in 2015. KEY RATING DRIVERS Retail Operating Declines: Rite Aid began to see material operating declines (before the contribution of EnvisionRx, acquired June 2015) beginning 2016, with retail EBITDA declining to $950 million after three years at $1.3 billion. First-half 2017 (1H17) retail EBITDA fell a further $200 million from 1H16 to around $300 million, with full-year EBITDA (prior to the impact of Walgreens divestitures) projected around $650 million. EBITDA declines have been the result of both retail pharmacy sales and margin erosion. Comps in 2016 fell 2.2% after several years of modestly positive results. Pharmacy comps, which began to slow in 2015 as the company cycled through a period of strong Medicaid expansion, turned negative to -3% in 2016 and weakened to -5% in 1H17. Comp script count was relatively flat in 2016 and down around 1.5% in 1H17, below the modestly positive industry trends. Accelerating market share loss is cause for concern, and an issue Rite Aid will need to address post the Walgreens transaction process in order to stabilize results. Fitch believes Rite Aid has had challenges winning new and maintaining existing contracts for in-network inclusion given the prior assumption that Rite Aid would be fully acquired by Walgreens. Front-end comps have recently been relatively flat, in line with industry peers and likely represent some share loss to discount channels, including online-only merchants. These trends may also be due to weak pharmacy traffic limiting add-on purchases. The majority of stores divested to Walgreens are in the Eastern part of the U.S., including most of the chain's Southeastern footprint and significant reductions in states such as New York, New Jersey, Massachusetts, and Maine. Rite Aid's pro forma base of around 2,550 stores is most concentrated in California and Pennsylvania (over 500 stores each), New York (over 300 stores) and Michigan (nearly 300 stores). Most of Rite Aid's pro forma footprint will be on the West Coast and Northeastern U.S. with some exposure to the Midwest (Michigan and Indiana). Compounding Rite Aid's sales challenges, retail gross margin in 2016 fell 80bps in 2016 to 27.5% and an additional 100bps in 1H17 on reimbursement rate cuts and deleverage of fixed expenses. Once the Walgreens transaction is consummated, Rite Aid has an option to become a partner in Walgreen's generic drug purchasing organization, which could somewhat reduce the pace of declines. However, Fitch expects retail pharmacy gross margins to continue to decline; therefore, modestly positive comps are necessary to maintain retail EBITDA stability near the $650 million level expected in 2017 (around $350 million pro forma for store divestitures to Walgreens). Thus far, Fitch has not modelled for any impact on total coverage, volume, or pricing based on potential changes to the Affordable Care Act (ACA) or other legislative activity affecting the pharmaceutical industry. Growth Continues at EnvisionRx: Rite Aid's full-service PBM, EnvisionRx, produced 2016 revenue and EBITDA of $6.4 billion and $190 million, respectively. Fitch views the addition of EnvisionRx to Rite Aid's operating profile as a positive, as EnvisionRx will enable the company to expand its distribution channels by getting a foothold in the specialty and mail-order channels. The acquisition was supported by Rite Aid's improved credit metrics and cash flow profile over the preceding three years, enabling it to start making investments to strengthen its competitive positioning in the complex and evolving healthcare landscape. EBITDA has grown 20%-30% on a yoy basis in the last several quarters, and Fitch expects future growth to be fueled by additional contract wins and growth in its specialty business. If the revised Walgreens transaction closes as proposed, EnvisionRx would represent approximately one-third of overall corporate EBITDA. Ample Liquidity: Rite Aid has maintained ample liquidity ($1.4 billion in the most recent quarter and at least $950 million for the past five years) supported by a borrowing base that includes prescription files and inventory. Despite a history of operating challenges, Rite Aid has maintained solid liquidity given its valuable asset base. The value of Rite Aid's asset base is supported by the 11.5x EBITDA multiple implied by Walgreen's original offer to buy Rite Aid in October 2015 for $17.2 billion, as well as the 16x multiple Walgreens is paying for 1,932 stores. Walgreens recently announced it intends to close 600 of these stores and transfer prescription files to nearby Walgreens locations, further illustrating the value placed on prescription files. Fitch expects Rite Aid would need to downsize its current $3.7 billion revolving credit facility (RCF) size to around $2.5 billion but expects pro forma liquidity to remain near $1 billion. Rite Aid's liquidity position should provide it with flexibility to navigate through its current operating challenges. RECOVERY CONSIDERATIONS Current Recovery Considerations: The issue ratings below are derived from the IDR and the relevant Recovery Rating. Fitch's recovery analysis, which has not factored in the proposed store sale and associated debt repayment, assumes a distressed enterprise value of approximately $6 billion on Rite Aid's existing inventory, receivables, prescription files and owned real estate. The recovery analysis will be updated as Rite Aid pays down debt. The $3.7 billion RCF due January 2020 has a first lien on the company's cash, accounts receivable, investment property, inventory, and script lists, and is guaranteed by Rite Aid's subsidiaries. This results in outstanding recovery prospects (91%-100%) that support the 'BB/RR1' rating. The senior secured credit facility requires the company to maintain a minimum fixed charge coverage ratio of 1x only if availability on the RCF is less than $175 million at any time. The $970 million in Tranche 1 and Tranche 2 term loans have a second lien on the same collateral as the revolver and term loans and are guaranteed by Rite Aid's subsidiaries. These are also expected to have outstanding recovery prospects and are rated 'BB/RR1'. The existing $3.5 billion guaranteed unsecured notes are expected to have average recovery prospects (31%-50%) and are therefore rated 'B/RR4'. The approximately $420 million unsecured non-guaranteed notes are assumed to have poor recovery prospects (0%-10%) in a distressed scenario. Pro Forma Recovery Considerations: Following the sale of approximately 43% of Rite Aid stores to Walgreens, Rite Aid's pro forma business profile could yield a distressed enterprise value of approximately $4.5 billion-$5.0 billion on Rite Aid's estimated pro forma $3 billon-$3.5 billion liquidation value on inventory, receivables, prescription files, owned real estate, as well as a $1.5 billion enterprise value for EnvisionRx. The $1.5 billion for the healthy EnvisionRx business values the company at 7x 2017 EBITDA and well below the $2 billion and 13x EBITDA Rite Aid paid for the business in 2015. Over the past several years, PBM valuations have declined, with publicly held Express Scripts Holding Company trading between 6x-8x EBITDA over the past year. Fitch expects Rite Aid will direct most of its approximately $4 billion in proceeds from the Walgreens transaction, which it expects to receive through March 2018, to debt repayment. Fitch assumes Rite Aid could entirely repay its $1 billion in first-lien term loans and $1.7 billion in guaranteed unsecured notes maturing 2020 and 2021, with the remaining proceeds use to pay down existing revolver borrowings. Fitch also assumes Rite Aid would downsize its $3.7 billion RCF to around $2.5 billion given the reduction to collateral including pharmacy scripts and inventory. As a result, Rite Aid's pro forma capital structure could include the downsized $2.5 billion credit facility, $1.8 billion in guaranteed unsecured notes due 2023, and approximately $420 million in nonguaranteed unsecured notes due 2027/2028. Given these assumptions around pro forma distressed enterprise value and capital structure, the downsized RCF and remaining $1.8 billion of guaranteed unsecured notes would be expected to have outstanding recovery prospects (91%-100%). The approximately $420 million unsecured non-guaranteed notes would be expected to recover alongside operating lease claims and may have average (31%-50%) or good (51%-70%) recovery prospects. Fitch expects to update its recovery analysis upon further details regarding debt paydown plans and resulting capital structure. DERIVATION SUMMARY Rite Aid's rating incorporates its weak position in the relatively stable U.S. drug retail business and its high leverage. The company's drug retail business, representing around two-thirds of corporate EBITDA following the sale of stores to Walgreens, is expected to continue losing share, although the company's EnvisionRx PBM - representing Rite Aid's remaining EBITDA - should grow modestly over time. The rating considers the expectation of over $4 billion of debt paydown yielding modest improvement to leverage, but also a significant improvement to the company's recovery prospects in a liquidation scenario. Rite Aid has significantly smaller operating scale and profitability metrics than Walgreens (BBB/Stable) and CVS Health Corp, which may have a negative impact on its relative ability to compete for inclusion in pharmacy networks. Rite Aid's cash flow characteristics (current and pro forma) are weaker than those of each of these companies and its leverage profile is significantly higher, limiting its ability to invest meaningfully in its business. Rite Aid's ratings are similar to those of SUPERVALU INC. (B/Stable), a grocery distributor and retailer with somewhat weak local market share positions, leading to recent operating declines, but significantly lower leverage. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include (note that 2017 does not assume any impact from the Walgreens transaction): --Prior to the impact of the Walgreens transaction, Rite Aid's EBITDA (inclusive of stores and EnvisionRx) is expected to decline to around $850 million in 2017 compared to $1.1 billion and $1.4 billion in 2016 and 2015, respectively, on low single digit comps decline, similar to the 2.2% decline in 2016. Retail gross margin is expected to remain under pressure due to reimbursement rate cuts in the pharmacy business. --EnvisionRx's 2017 EBITDA could be around $215 million versus around $190 million in 2016; EBITDA beginning 2018 could continue to grow on additional contract wins and growth in its specialty business. --Following the completion of the Walgreens transaction, pro forma EBITDA is estimated to be in the $550 million-$600 million range, including around $215 million contribution from EnvisionRx and the remainder from Rite Aid's stores. EBITDA could decline modestly beginning 2018 unless Rite Aid can reverse recent retail comps trends. --Fitch expects FCF to be around breakeven in 2017 excluding the $325 million breakup fee from Walgreens' unsuccessful takeover bid and could also be near breakeven on a pro forma basis. Adjusted leverage prior to Walgreens-divested EBITDA loss and debt paydown could be in the low- to mid- 8.0x range in 2017 but decline to around 7.0x on a pro forma basis assuming $4 billion of debt paydown using Walgreens transaction proceeds. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action A positive rating action could result from sustained positive comparable store sales leading to EBITDA growth, coupled with reduced debt, which would yield adjusted debt/EBITDAR towards mid-5.0x. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action A negative rating action could result from deteriorating sales and profitability trends that lead to negative FCF and leverage towards 8x. LIQUIDITY Rite Aid had total liquidity of $1.4 billion as of Sept. 2, 2017, consisting of $239 million in cash and $1.4 billion of revolver availability. Fitch expects FCF to be around flat in 2017 (prior to the $325 million breakup fee from Walgreens). On a pro forma basis, given Fitch's assumptions as to RCF size and borrowing base, liquidity is expected to remain around $1 billion. This liquidity would enable Rite Aid to fund operations should EBITDA declines continue beyond Fitch's current expectations. FULL LIST OF RATING ACTIONS Fitch has affirmed the following ratings and removed them from Rating Watch Negative: Rite Aid Corporation --Long-Term IDR at 'B'; --Secured revolving credit facility and term loans at 'BB'/'RR1'; --Guaranteed senior unsecured notes at 'B'/'RR4'; --Non-guaranteed senior unsecured notes at 'CCC+'/'RR6'. The Rating Outlook is Stable. Contact: Primary Analyst David Silverman, CFA Senior Director +1-212-908-0840 Fitch Ratings, Inc. 33 Whitehall St. New York, NY 10004 Secondary Analyst Monica Aggarwal, CFA Managing Director +1-212-908-0282 Committee Chairperson Patrick Finnegan, CFA Senior Director +1-646-582-4620 Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and exclude restructuring charges. For example, Fitch added back $24 million in non-cash stock-based compensation and $14 million in other restructuring charges to its EBITDA calculation in 2016. Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary. Applicable Criteria Corporate Rating Criteria (pub. 07 Aug 2017) here Non-Financial Corporates Notching and Recovery Ratings Criteria (pub. 16 Jun 2017) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here#solicitation Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: here. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. 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In issuing and maintaining its ratings and in making other reports (including forecast information), Fitch relies on factual information it receives from issuers and underwriters and from other sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. 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