Rite Aid Corp (RADCQ)

[JPetroInc]

Fitch Rates Rite Aid's New Secured Notes 'BB-'/'RR1'; Affirms Existing Ratings

Wed 29 Jul, 2020 - 11:02AM ET

https://www.fitchratings.com/research/corporate-finance/fitch-rates-rite-aid-new-secured-notes-bb-rr1-affirms-existing-ratings-29-07-2020

Fitch Ratings - New York - 29 Jul 2020: Fitch rates Rite Aid's new secured notes 'BB-'/'RR1' and affirms the company's remaining ratings, including its Long-Term Issuer Default Rating (IDR) at 'B-'. The Rating Outlook is Stable. Rite Aid's new $850 million of 8% secured notes due November 2026, plus approximately $202 million in cash will be issued in exchange for approximately $1.06 billion of the company's existing 6.125% guaranteed, unsecured notes due 2023. The new notes are pari passu with the company's recently issued $600 million of secured notes, which were issued for a like amount of unsecured 2023 notes. The notes have a second lien on ABL collateral, which largely includes inventory, prescription files and some receivables, and a first lien on most remaining assets.

The exchange reduces the principal amount of Rite Aid's next maturity, unsecured notes due April 2023, from $1.15 billion to $91 million. Assuming the company uses ABL borrowings to fund most of the cash portion of the exchange, the transaction is essentially leverage-neutral although a modest negative to liquidity, which remains ample at a projected pro forma level of $1.5 billion compared with $1.7 billion as of May 30, 2020.

Rite Aid's ratings reflect continued operational challenges, which have heightened questions regarding the company's longer term market position and the sustainability of its capital structure. Persistent EBITDA declines have led to negligible to modestly negative FCF and elevated adjusted debt/EBITDAR in the low- to mid-7.0x range in recent years, despite some signs of pharmacy sales stabilization over the past year. Fitch believes that operational challenges include both a challenged competitive position in retail and, more recently, sector-wide gross margin contraction resulting from reimbursement pressure. A new leadership team, installed over the past year, is implementing initiatives to drive growth across the business while streamlining costs. Recent results have shown some early evidence of a stabilizing trajectory despite operational challenges related to the coronavirus pandemic, which is expected to somewhat negatively impact 2020 EBITDA.

Mitigating factors to these concerns continue to including Rite Aid's ample liquidity of well over $1 billion, supported by a rich asset base of pharmaceutical inventory and prescription files. Other positives include the somewhat more stable EnvisionRx pharmacy benefits manager (PBM) business, representing around 30% of total EBITDA, and Rite Aid's good real estate position in local markets, somewhat mitigated by lack of broad-based national presence. The company also has no near term maturities, with nothing due prior to its approximately $91 million (following the $1.06 billion exchange) notes maturity in April 2023.

KEY RATING DRIVERS

Coronavirus Pandemic: The coronavirus pandemic has caused significant changes to both near term U.S. consumer behavior and Fitch's expectations around U.S. retail sales through the next 12 to 18 months. Since shelter in place activity began in March, staples retailers like Rite Aid have seen sales uplift as consumers purchase essential general merchandise items like grocery and cleaning. Retailers which have experienced topline uplifts have also seen operating expense growth, due largely to higher employee wages and 'hero' bonuses as well as enhanced cleaning expenses. Higher online order penetration has also raised operating costs given incremental delivery expense.

In addition to the above trends, Rite Aid has been negatively impacted by declines in high-margin acute prescription counts, which are correlated to reduced doctor visits during shelter-in-place activities. These declines have been somewhat mitigated by strong mail-order prescription growth at EnvisionRx, which is in the process of being rebranded to 'elixir'. Rite Aid's adjusted EBITDA for the quarter ending May 30, 2020 was essentially flat to the prior year at $100 million, with the company indicating a net negative EBITDA impact from the pandemic of $30 million. This negative impact was offset by growth in Medicare Part D enrollment at EnvisionRx and operating expense management. Fitch expects the negative EBITDA impact to subside during the remainder of 2020, given expectations of improving acute prescription trends and reduced employee bonuses. EBITDA in 2020 could therefore grow modestly from the $530 million level in 2019, largely due to enrollment growth at EnvisionRx.

Fitch expects a U.S. consumer spending slowdown through much of 2021, given the likelihood of weak macroeconomic factors including unemployment and wage growth exiting the pandemic. The consumer spending slowdown is expected to have limited impacts to Rite Aid's pharmacy and EnvisionRx businesses, though could modestly, negatively impact its front end business given potential share shifts to lower price alternatives to the drugstore channel.

Rite Aid has maintained good liquidity through the pandemic. As of May 30, 2020, Rite Aid's $1.7 billion of liquidity included approximately $200 million in cash and $1.5 billion in availability on its $2.7 billion revolver, after deducting $1.3 billion in borrowings and $100 million in outstanding letters of credit. Rite Aid's ample liquidity, and lack of maturities prior to April 2023, when $91 million of unsecured notes mature, should enable the company to manage through any near term challenges related to the pandemic or related slowdowns in consumer spending.

Competition Intensifying: Drug retail competition is intensifying from current and newer players. Existing participants are exploring partnerships and M&A to reduce costs and strengthen customer connections. CVS Health Corp's acquisition of insurer Aetna Inc. and Walgreens' numerous partnerships across healthcare, retail and technology are examples of leading drug retailers exploiting their scale to fortify share. These retailers are also increasingly negotiating narrow and preferred networks to fortify market share. Finally, there exists some threat of new entrants, most notably from Amazon.com, Inc. (A+/Positive), which acquired online pharmacy Pillpack in 2018.

Rite Aid Structurally Disadvantaged: While Rite Aid has good local market share positions, its scale and geographic concentration relative to Walgreens and CVS may negatively impact its ability to compete for inclusion in pharmaceutical contracts, particularly as these players explore preferred and narrow contracts. Following the transfer of approximately 40% of its store base to Walgreens in 2017/2018, Rite Aid's footprint includes approximately 2,500 stores, almost half of which are in four states, compared with the national footprints of approximately 10,000 and 9,300 for CVS (including pharmacies within Target stores) and Walgreens U.S., respectively. In addition, Rite Aid's limited FCF generation yields reduced ability to make customer-facing investments to drive loyalty and traffic.

Gross Margin Pressure: Reimbursement pressure on gross margin is intensifying across the retail pharmacy industry. Structural margin pressure has been a consequence of increased penetration of the government as a pharmaceutical payer under the Medicare and Medicaid programs, ongoing pressure from commercial payers and a mix shift toward the "90-day at retail" offering. Growth in preferred/narrow networks may also be a factor, as players sacrifice margin for network inclusion to drive volume. This pressure was somewhat mitigated by the growth in generic penetration over the last few years, though this has tapered off somewhat given a lighter calendar of branded expirations.

Weakened Retail Operations: Rite Aid's pro forma EBITDA steadily declined from approximately $850 million in 2015 to approximately $525 million in the TTM ending May 30, 2020. Weak pharmacy trends drove overall pro forma same store sales (SSS) to negative 2.2% in 2016 and negative 2.9% in 2017, though SSS improved to 0.5% in 2018 and 1.1% in 2019 as pharmacy sales improved but front-end sales worsened. Negative SSS and declining reimbursement rates drove EBITDA margins to approximately 2.3% in the TTM ending May 30, 2020, from the 4% range in 2015. Fitch believes a protracted transaction process with Walgreens, which originally proposed to acquire Rite Aid in October 2015, created uncertainty about Rite Aid's future, affecting its strategic planning and pharmacy contract negotiations.

Relatively Stable PBM Business: Results at EnvisionRx have been more stable than retail albeit somewhat disappointing relative to original expectations, with around $186 million of EBITDA in the TTM ending May 30, 2019, similar to full-year EBITDA of around $190 million in 2016 and 2017. The 2015 acquisition of EnvisionRx allowed Rite Aid to diversify its business and provide exposure to the relatively faster growing specialty pharmaceuticals business and the mail-order channel. Fitch believes this business was also negatively impacted by the Walgreens transaction process. Revenue and EBITDA trends have recently begun to improve, however, with 4Q19 and 1Q20 EBITDA up 33% and nearly 70%, respectively, as recent initiatives to drive enrollment appear to be bearing fruit.

New Initiatives Could Support EBITDA Stabilization: A new management team, installed over the past year, is undertaking a number of initiatives to improve topline and expense management. To drive revenue growth, the company sees opportunities to cross market its PBM and retail assets to mid-market employers, Medicare Part D participants, and other target groups. The company is also investing in a more holistic care approach with its pharmacy customers to drive loyalty and incremental purchases, and is adding omnichannel capabilities like improved digital/mobile shopping experience and in-store pick-up options like lockers. At the same time, the company has undertaken actions including headcount reductions, advertising and shrink to reduce expenses by approximately $100 million on an annualized basis; Fitch expects some of these savings will be used to support spending on growth initiatives.

Rite Aid's initiatives appear to be showing some signs of traction, albeit somewhat obfuscated by the coronavirus pandemic. For example, EBITDA was essentially flat around $100 million in the quarter ending May 30, 2020, despite an estimated net negative $30 million impact from the pandemic. Growth in Medicare Part D enrollment, good pharmacy trends excluding acute prescriptions, and cost reductions mitigated these temporary challenges. With the negative impact of the coronavirus pandemic expended to lessen over the coming quarters, Fitch expects EBITDA could grow modestly in 2020 to around $550 million from around $530 million in 2019, and grow modestly toward $570 million in 2022.

Limited FCF: FCF has been somewhat volatile in recent years due to working capital and other balance sheet movements related both to the store sale to Walgreens and periodic sales of receivables. Fitch expects Rite Aid's annual FCF to be near breakeven on average, given Fitch's EBITDA assumptions and around $225 million and $300 million of interest expense and capex, respectively. FCF in 2020 could be close to $100 million on working capital swings given efforts to reduce inventory levels. Rite Aid's minimal cash flow generation limits its ability to invest in its business relative to better-capitalized peers, and address its capital structure.

Elevated Leverage; Opportunistic Repayments: Adjusted debt/EBITDAR, which was elevated at around 7.0x in 2016 prior to store divestitures, was approximately 7.1x in 2019 and could modestly improve to the high-6.0x range given some EBITDA growth beginning 2020. Following Rite Aid's July 2020 exchange, its next maturity is $91 million (of notes due April 2023, but it will need to address this debt prior to Dec. 31, 2022; otherwise the company's ABL revolver and First-In, Last-Out (FILO) term loan mature on this date.

In October 2019, the company announced a below-par tender for up to $100 million principal amount of its 2027/2028 notes and indicated that it privately repurchased $84 million principal amount of these notes from a seller, also below par. The company tendered for approximately $73 million of the unguaranteed unsecured notes maturing 2027/2028 in October and November of 2019. Fitch views these actions as opportunistic as it is using asset sale proceeds to proactively reduce the debt balance. In January 2020, the company exchanged $600 million of unsecured notes due April 2023 for a like amount of secured notes due November 2026.

Strong Liquidity and Asset Base: Rite Aid's ample liquidity of over $1 billion should provide flexibility to navigate through its current operating challenges. Given the reduced store portfolio, Rite Aid replaced its $3.7 billion revolving credit facility with a $2.7 billion facility, adding a $450 million FILO term loan in December 2018. Proceeds from the FILO term loan were used to reduce revolver borrowings, providing Rite Aid with additional liquidity. Rite Aid's asset value is supported by the 11.5x EBITDA multiple implied by Walgreens' original offer to buy it in 2015 for $17.2 billion and the 16.0x multiple Walgreens ultimately paid for 1,932 stores.

Complex Industry Fundamentals: Despite projections of continued modest growth in pharmaceuticals revenue, the healthcare industry remains complex given intricate relationships between critical constituents in the industry, strategic initiatives by large players and regulatory overlay. Rite Aid benefits from close relationships with end customers, which Fitch believes is a critical structural advantage for drug retailers, and some business diversification through EnvisionRx. However, Rite Aid's challenged operations and regional focus following its store divestiture has weakened its competitive positioning, particularly given the rise of preferred and narrow pharmaceutical networks.

DERIVATION SUMMARY

Rite Aid's 'B-' rating incorporates its weak position in the relatively stable U.S. drug retail business and its high lease adjusted leverage (capitalizing rent expense at 8x) at around 7x. The company's drug retail business, representing approximately two-thirds of total EBITDA following the sale of roughly 43% of stores to Walgreens Boots Alliance, Inc. (BBB-/Stable), is expected to continue losing share, although the company's EnvisionRx PBM -- representing Rite Aid's remaining EBITDA -- should grow modestly over time.

Rite Aid has significantly smaller scale and weaker operating metrics than Walgreens 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 is minimal to modestly negative, and its leverage profile is significantly higher than its larger peers, limiting its ability to invest meaningfully in its business.

Rite Aid's 'B'-rated retail peers include Signet Jewelers Limited. Signet's 'B' IDR and Negative Outlook reflect the significant business interruption from the coronavirus and the implications of a downturn in discretionary spending that Fitch expects could extend well into 2021. Fitch anticipates a sharp increase in adjusted leverage to the mid-10.0x range in 2020 from 5.3x in 2019 based on EBITDA declining to approximately $70 million from $470 million in 2019 on a nearly 30% sales decline to $4.4 billion. Adjusted leverage could improve to around mid-5x in 2021, assuming sales declines of around 10% and EBITDA declines of around 15% to 20% from 2019 levels. Excluding Signet's recent revolver draw, which Fitch assumes is repaid in 2021, 2020 adjusted leverage would be closer to 9.0x.

KEY ASSUMPTIONS

--Fitch expects 2020 revenue to grow around 5% to $23 billion from $22 billion in 2019, given strength in grocery and cleaning supplies through the coronavirus pandemic and growth at EnvisionRx from increased enrollment and mail order volume. EBITDA could similarly be up around 5% to the $550 million range from approximately $530 million in 2019, with margins remaining near the prior year's 2.4% as increased operating costs due to the pandemic are mitigated by expense management efforts.

--Beginning 2021, Rite Aid's topline could grow around 1% annually assuming some of its topline initiatives gain traction. Pharmacy and EnvisionRx revenue could grow in the low-single digits, with flattish to modestly negative growth at Rite Aid's front-end given ongoing competition from discount and online channels. Assuming some ongoing cost reduction efforts mitigate continued industry gross margin pressures in the pharmacy, EBITDA could grow modestly faster than revenue toward around $570 million in 2022. Modest EBITDA growth is expected at both Rite Aid's retail operation and at EnvisionRx.

--FCF, which has been somewhat volatile in recent years following working capital movements related to the asset sale to Walgreens and a 2019 sale of receivables, is expected to be positive at around $90 million in 2020, largely due to management efforts to control inventory levels. Fitch expects FCF to be near breakeven beginning 2021, assuming EBITDA of $550 million to $570 million, and approximately $225 million and $300 million of interest and capex, respectively.

--Adjusted debt/EBITDAR (capitalizing leases at 8x), could trend in the high-6.0x range beginning 2020, slightly below the 7.1x level from 2020 on modest EBITDA growth and FCF deployment toward debt reduction in 2020. The company has recently announced the results of an exchange where $1.06 billion of unsecured notes are being exchanged for $850 million of new secured notes and approximately $202 million of cash. Fitch expects Rite Aid could fund the cash portion from ABL borrowings although use FCF to repay revolver balances as the year progresses.

--Fitch has not currently modeled 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.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

--Evidence of positive results from Rite Aid's recently announced topline initiatives, yielding sustained positive revenue trends, stabilized EBITDA in the mid-$500 million level, modestly positive FCF, and adjusted debt/EBITDAR (capitalizing leases at 8x) around 7x .

Factors that could, individually or collectively, lead to negative rating action/downgrade:

--Deteriorating sales and profitability trends that lead to EBITDA sustained below $500 million, consistently negative FCF and adjusted debt/EBITDAR (capitalizing leases at 8x) toward 8.0x. Rite Aid's inability to stabilize operations would raise concerns regarding the company's capital structure sustainability, which is more representative of the 'CCC' category.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

LIQUIDITY AND DEBT STRUCTURE

Ample Liquidity: Rite Aid had liquidity of $1.7 billion as of May 30, 2020, supported by $1.5 billion in availability under the $2.7 billion ABL facility, net of letters of credit, and approximately $200 million in cash on hand. The company refinanced its prior credit facility with a $2.7 billion ABL and a $450 million FILO term loan in December 2018, extending maturities to December 2023. The company's closest debt maturity is the remaining $91 million (following the $1.06 billion exchange) 6.125% guaranteed unsecured notes which mature April 2023. However, the company will face a springing maturity under the secured credit facility on Dec. 31, 2022 if they fail to refinance the 6.125% notes prior to this date.

On Oct. 15, 2019, Rite Aid announced a tender offer to repurchase up to $100 million of the unguaranteed unsecured notes maturing 2027/2028. The company ultimately repurchased approximately $73 million principal amount of the unguaranteed unsecured notes in October and November of 2019 for approximately $50 million. During 3Q19, the company also privately repurchased $84 million principal amount of these notes for approximately $50 million in cash. Debt repurchases were funded with available liquidity, inclusive of an estimated $150 million in cash proceeds from asset sales to Walgreens. In February 2020, the company exchanged $600 million of unsecured notes due 2023 for a like amount of new, secured notes due July 2025.

The company is closing an exchange whereby $1.06 billion of unsecured notes due April 2023 will be exchanged for $850 million in new secured notes due November 2026 and approximately $202 million in cash. The new notes are pari passi with the recently issued $600 million of notes; these notes are secured by a second lien on ABL collateral - which includes most working capital assets such as inventory and receivables as well as prescription files - and a first lien on most of Rite Aid's remaining assets, including property, plant and equipment. Fitch expects Rite Aid to fund the cash portion with ABL borrowings but could use its projected $90 million of FCF in 2020 to pay down revolver balances.

On a pro forma basis following the exchange, Rite Aid's capital structure would include a projected $1.5 billion in ABL borrowings, its $450 million FILO term loan which is secured by ABL collateral, $1.45 billion in senior secured notes, $91 million of guaranteed unsecured notes, and $266 million of unguaranteed unsecured notes. Fitch expects ABL borrowings are seasonally elevated and projects year-end 2020 borrowings to be around $800 million, compared with $650 million at the end of 2019. Given this assumption, Fitch projects total adjusted debt/EBITDAR to be around 6.9x in 2020.

Rite Aid maintains solid liquidity given its valuable asset base, despite a history of operating challenges. 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 and the 16.0x multiple Walgreens paid for 1,932 stores. Following the transfer Walgreens announced plans to close 600 of these stores and transfer prescription files to nearby Walgreens locations, further illustrating the value placed on prescription files.

Recovery:

Rite Aid's business profile could yield a distressed enterprise value of approximately $4.6 billion on Rite Aid's estimated $3.4 billion liquidation value on inventory, receivables, prescription files, owned real estate and a $1.2 billion enterprise value for EnvisionRx. Fitch notes that its approximately $7.25 value ascribed per prescription file could prove conservative given current transaction multiples in the low- to mid-teens. The $1.2 billion for the healthy EnvisionRx business values the company at 7.0x EBITDA of $170 million, slightly above the $168 million Rite Aid reported in 2019. This is well below the $2 billion, or 13.0x EBITDA Rite Aid paid for the business in 2015. PBM valuations have declined over the past several years, although Express Scripts Holding Co. (BBB/Stable) was acquired by Cigna Corporation at an enterprise valuation of approximately 9.0x TTM EBITDA.

The $4.6 billion in resulting liquidation value exceeds Fitch's assessment of Rite Aid's $3.0 billion valuation as a going concern. The going concern valuation is based upon $500 million in distressed EBITDA, modestly below the current run rate, as Fitch views Rite Aid's current operating trajectory as somewhat distressed. Fitch assumes Rite Aid could generate a 6.0x EBITDA multiple in a going-concern sale, somewhat lower than valuations implied in the Walgreens process due to ongoing declines in the company's operations.

The company replaced its $3.7 billion ABL facility with a new $2.7 billion ABL facility, given lower collateral levels, and subsequently issued a $450 million FILO term loan in late December 2018. From Aug. 31, 2019 to Nov. 30, 2019, the company reduced principal borrowings of the unguaranteed notes maturing 2027/2028 by $157 million through various tender offers and open market repurchases. Additionally, in February 2020, the company completed an exchange whereby $600 million of the guaranteed unsecured notes maturing 2023 were exchanged for new 7.5% secured notes maturing 2025. The new notes are secured by a second lien on ABL collateral - which includes most working capital assets and prescription files - and a first lien on most of Rite Aid's remaining assets, including property, plant and equipment. The company is currently completing an exchange whereby approximately $1.06 billion of the remaining guaranteed unsecured notes will be exchanged into $850 million of new 8% secured notes maturing November 2026 and approximately $202 million of cash.

Following the completion of the exchange, Rite Aid's pro forma capital structure includes the $2.7 billion credit facility, $450 million FILO term loan due 2023, $1.45 billion of secured notes due 2025/2026, $91 million in guaranteed unsecured notes due 2023 and $266 million in nonguaranteed unsecured notes due 2027/2028.

Given a $4.6 liquidation value and a 10% reduction for administrative claims, the ABL - which Fitch assumes to be 80% drawn - , $450 FILO term loan and $1.45 billion in secured notes would be expected to have outstanding recovery prospects (91%-100%) and are thus rated 'BB-'/'RR1'. The $91 million of remaining guaranteed unsecured notes would be expected to have superior recovery prospects (71%-90%) and are rated 'B+'/'RR2'. The approximately $266 million unsecured nonguaranteed notes would be expected to have poor (0%-10%) recovery prospects and are therefore rated 'CCC'/'RR6'.

SUMMARY OF FINANCIAL ADJUSTMENTS

Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and exclude charges related to LIFO adjustments, mergers & acquisitions, restructuring, and legal settlements. For example, Fitch added back $13 million in non-cash stock-based compensation and $14 million in other excluded net charges to its EBITDA calculation for the LTM period ended May 30, 2020. Fitch has adjusted historical and projected debt by adding 8x yearly operating lease expense.

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG CONSIDERATIONS

The highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.


Rating Actions

Rite Aid Corporation LT IDR B- Affirmed B-
•senior secured
LT BB- New Rating RR1
•senior unsecured
LT CCC Affirmed RR6 CCC
•senior secured
LT BB- Affirmed RR1 BB-
•senior unsecured
LT B+ Affirmed RR2 B+





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