Fitch Places Rite Aid on Rating Watch Positive
WBA will finance the deal with existing cash, new debt issuance and assumption of existing Rite Aid debt. The acquisition is expected to close in second half 2016, subject to approval by Rite Aid shareholders and antitrust regulators.
Fitch currently rates Rite Aid's long-term Issuer Default Rating (IDR) 'B'. As of Aug. 29, 2015, Rite Aid had $7.5 billion of debt outstanding. A full list of ratings is shown below.
KEY RATING DRIVERS
The merger will solidify WBA's dominant position in the U.S. retail prescription market with a combined sales base of $115 billion on approximately 13,000 stores and the #1 retail prescription share at 25%-26%, prior to any potential FTC-mandated closings or divestitures. There are about 13 states, primarily California and the East Coast, where WBA and Rite Aid have sizeable overlap that could raise antitrust concerns. The FTC has historically looked at competition within a two-mile operating radius in the drugstore space to determine store closings. Barring a significant number of store divestitures, Fitch expects that even with FTC mandated store closings in certain markets, WBA could capture or transfer some of the prescription volume of any closed stores (unless they are acquired by other retailers), mitigating some of the impact.
The Rating Watch Positive reflects a projected decline in financial leverage for the combined entity relative to standalone Rite Aid. On a pro forma basis, Fitch expects adjusted debt/EBITDAR for the combined company to be in 4.6x-4.8x range in 2015 (and 4.3x-4.5x including $1 billion in synergies) assuming a mainly debt financed deal (refinancing and assumption of Rite Aid's existing debt). This compares to 6.0x for Rite Aid on a stand-alone basis with a full year of EnvisionRx results.
Based on preliminary projections, Fitch expects that leverage could improve to the low-4x range within 24 months post the closing of the transaction, based on WBA's underlying EBITDA growth and the realization of $1 billion in synergies, but excluding any debt repayment. This would be representative of a low investment grade rating.
Rite Aid's operating metrics still significantly lag its larger peers, with average weekly prescriptions per store of 1,260 and EBITDA margin of 5.1%, versus Walgreen's retail EBITDA margin of approximately 6.5%-7% and CVS Caremark's retail EBITDA margin of 11.5%-12%, before corporate costs. However, Rite Aid's loyalty card program and remodeling activity have helped stabilize prescription volume and have resulted in modest front-end growth. Post-acquisition, Fitch expects Rite Aid's store base, currently at around 4,600 stores, to benefit from significant capital investment, which has been a major constraint given its highly levered balance sheet. Merger related risks include lower than expected improvement in Rite Aid's sales and profitability and systems related integration issues.
KEY ASSUMPTIONS
Fitch's key assumptions assuming that the deal closes in the second half of 2016:
--Adjusted debt/EBITDAR for the combined company to be in 4.6x-4.8x range in 2015 (and 4.3x-4.5x including $1 billion in synergies) assuming a mainly debt financed deal (refinancing and assumption of Rite Aid's existing debt). This compares to 6.0x for Rite Aid on a stand-alone basis with a full year of EnvisionRx results.
--Leverage improves to the low-4x range within 24 months post the closing of the transaction, based on WBA's underlying EBITDA growth and the realization of $1 billion in synergies, but excluding any debt repayment.
Fitch's key assumptions for Rite Aid on a standalone basis:
--Rite Aid's EBITDA before the contribution from EnvisionRx is expected to be sustainable at $1.3 billion over the intermediate term, with same store sales growth of 2% to 3%.
--EnvisionRx is projected to have 2015 calendar year revenues of approximately $5 billion and 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).
--Fitch expects FCF to be in the $300 million range in fiscal 2016 and $200 million thereafter. The EnvisionRx acquisition is expected to be FCF neutral in the first year but should be FCF positive thereafter in line with EBITDA growth.
RATING SENSITIVITIES
Fitch would expect to upgrade Rite Aid's existing debt to the low 'BBB' category assuming the merger closes as contemplated and there are no material changes to Fitch's expectations. If the merger is terminated, future developments that may, individually or collectively, lead to a positive rating action includes Rite Aid sustaining positive comparable store sales and EBITDA in the $1.5 billion range or better, enabling to company to further reduce debt and reducing adjusted debt/EBITDAR towards the mid-5.0x range.
A negative rating action for Rite Aid on a standalone basis could result from deteriorating sales and profitability trends that take leading to negative FCF and leverage to over 7.0x.
LIQUIDITY - for Rite Aid on a Standalone Basis
At Aug. 29, 2015, liquidity was $1.4 billion, comprised of $153 million in cash and $1.2 billion availability on the $3.7 billion revolver.
Rite Aid has maintained liquidity in the $950 million to $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 EnvisionRx 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.
RECOVERY CONSIDERATIONS - for Rite Aid on a Standalone Basis
The issue ratings shown are derived from the IDR and the relevant Recovery Rating. Fitch's recovery analysis assumes distressed enterprise value of approximately $6.0 billion on Rite Aid's existing inventory, receivables, prescription files and owned real estate.
The $3.7 billion revolving credit facility 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 gives them outstanding recovery prospects (91%-100%) that support their 'BB/RR1' rating. The senior secured credit facility requires the company to maintain a minimum fixed charge coverage ratio of 1.0x only if availability on the revolving credit facility 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 $3.5 billion guaranteed unsecured notes are expected to have average recovery prospects (31%-50%) and are therefore rated 'B/RR4'. The $423 million unsecured non-guaranteed notes are assumed to have poor recovery prospects (0%-10%) in a distressed scenario.
FULL LIST OF RATING ACTIONS
Fitch has placed the following ratings for Rite Aid on Rating Watch Positive:
Rite Aid Corporation
--IDR 'B';
--Secured revolving credit facility 'BB/RR1';
--Second lien senior secured term loans 'BB/RR1';
--Guaranteed senior unsecured notes 'B/RR4';
--Non-guaranteed senior unsecured notes 'CCC+/RR6'.
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