OREANDA-NEWS. Fitch Ratings views Rite Aid's announcement that it will acquire Envision Pharmaceutical Services (EnvisionRx), an independent full-service pharmacy benefit management (PBM) company, as a positive move as it will enable the company to expand its distribution channels by getting a foothold in the specialty and mail-order channels.

The acquisition is supported by Rite Aid's ability improved credit metrics and cash flow over three years, enabling it to start making investments that will help strengthen its competitive positioning over the medium-longer term in the complex and evolving healthcare landscape where there is increased demand for an integrated health and wellness offering.

The transaction is valued at approximately \$2 billion, which includes the value of an expected future tax benefit of \$275 million. Rite Aid expects to finance the deal through a \$1.8 billion issuance of guaranteed unsecured notes and \$200 million in Rite Aid stock, or approximately 27.9 million shares.

Proforma for the transaction, Rite Aid's adjusted leverage is expected to increase to 6.2x from 5.9x in fiscal 2015 (February 2015) versus Fitch's prior expectations that it would trend towards the mid-5x range over the next 24 months. However, Fitch expects leverage will get back to below 6x in 24 months assuming FCF is deployed towards debt reduction post the transaction.

The new notes are expected to be parri passu to Rite Aid's existing guaranteed notes which are substantially guaranteed by all Rite Aid subsidiaries which would include EnvisionRx going forward. Given that PBMs are typically asset-light businesses, Fitch expects the guarantees to essentially come from existing subsidiaries. This could potentially have a negative recovery implication for the guaranteed unsecured notes currently rated 'B+/RR3' with a RR3 rating, and with current recovery prospects of 51% to 70%.

EnvisionRx is a national, full-service pharmacy benefit management (PBM) company with projected 2015 calendar year revenues of approximately \$5 billion and projected 2015 calendar year EBITDA in a range of \$150 to \$160 million. Fitch expects EBITDA from this business could potentially double over the next five years on additional contract wins and growth in its specialty business (from a low base currently). The transaction is expected to be accretive to Rite Aid's earnings in the first full year following the closing of the transaction which is expected to close by September, 2015, subject to regulatory approvals and other customary closing conditions.

Fitch expects Rite Aid's EBITDA before the contribution from EnvisionRx to be sustainable at \$1.3 billion over the intermediate term, enabling the company to dedicate increased capex toward store remodels and some store relocation activity, and to devote FCF to debt reduction. While Fitch expects gross margin to decline in the 20 bps- 30 bps range annually, due to ongoing pharmacy reimbursement rate cuts that will put some pressure on the current LTM EBITDA margin of 5.1%, Fitch expects same-store sales to grow at 2%-3% over the next 24 months, resulting in relatively flat EBITDA levels. The same-store sales projection is based on front-end same-store sales of 1%, prescription volume growth of 1.5% - 2.0% and some pharmacy inflation.

Rite Aid's operating metrics still significantly lag its larger peers, with average weekly prescriptions per store of 1,260 and retail EBITDA margin of 5.1%, versus 6.7% for Walgreen Co. and 11.8% for CVS Caremark's (CVS) retail business, pre corporate costs. However, its loyalty card program and remodeling activity have helped stabilize prescription volume and have resulted in modest front-end growth. In addition, the acquisition will now provide some exposure to other distribution channels and Fitch expects Rite Aid's market share to remain relatively stable over the intermediate term.

Rite Aid has maintained liquidity in the \$950 million -- \$1.3 billion range for the past three years. Fitch expects FCF, net of capex of \$525 million, to be approximately \$350 million after taking into account \$70 million related to the acquisition of Health Dialog and RediClinic in fiscal 2015. Fitch expects FCF to be in the \$300 million range in fiscal 2016 and \$200 million thereafter. Fitch expects the acquisition to be FCF neutral in the first year (with project interest expense of \$130 million and capex of \$20 million largely offsetting the \$150 million to \$160 million projected 2015 EBITDA) but should be FCF positive thereafter in line with EBITDA growth. This should support further debt reduction, barring significant incremental capex spend or investments in the business, and bring back leverage from 6.2xpost acquisition to under 6x over the next 24 months.

RATING SENSITIVITIES

Positive Rating Action: A positive rating action could result if Rite Aid sustains positive comparable store sales and EBITDA in the \$1.5 billion range or better, enabling to company to further reduce debt and adjusted debt/EBITDAR towards the mid-5.0x range over the next 24 months.

Negative Rating Action: A negative rating action could result from deteriorating sales and profitability trends that take leading to negative FCF and leverage to over 7.0x.

Fitch currently rates Rite Aid as follows:
--Long term IDR 'B';
--Secured revolving credit facility 'BB/RR1';
--First and second lien senior secured notes 'BB/RR1';
--Guaranteed senior unsecured notes 'B+/RR3'.
--Non-guaranteed senior unsecured notes 'CCC+/RR6'

The Rating Outlook is Positive.