My friends and I joke about the absurdly high contracts that middling athletes receive during the baseball season. When you have a palpably finite supply of players that your competitor peers are going after, the group-think leads to irrationality. You see transactions doomed from the start when teams like the Colorado Rockies pay $70 million for the services of Ian Desmond through his mid 30s.
These situations, when key industry players gather around to bid up so-so assets, remind me of the Animal House scene when Otter said: “No, I think we have to go all out. I think that this situation absolutely requires a really futile and stupid gesture be done on somebody’s part!”
We are living through the drugstore stock version of this impulse today.
As I write this, Fred’s (FRED) stock is up 85% on the news that it is acquiring 865 locations of Rite Aid (RAD) that were necessary to secure clearance antitrust clearance for its merger with Walgreens.
In all this excitement, investors seem to be forgetting that Rite Aid is a poor asset.
Investors are speaking as if Fred’s got a “steal” by getting each location for a cost of $1.1 million. I do not share in that sentiment. My view is that Fred’s purchase of 865 Rite-Aid locations will, in hindsight, prove to be a classic case study of the kind of market folly that pops up whenever you have a rising market mixed with cheap credit for corporate borrowers.
Despite having 4,600 locations, Rite Aid only brings in $125 million in profits per year. This means that each Rite Aid location, on average, makes $27,173 in net profit per year. I view this as folly because Fred’s is paying an average price of $1.1 million per year. That is a payment of 40x earnings for a business with a five-year rate of NEGATIVE sales growth of 1.5% per year.
And those are Rite Aid’s cheery figures coming out of the recession. Rite Aid lost money in 2000, 2001, and 2002, barely eked out a profit 2003-2005, and then lost money in 2006 through 2011 with a loss of $500 million in 2009.
In good times, Rite Aid locations give you anemic growth. In bad times, it gives you cratering losses. The only reason corporations like Fred’s and Kroger bid for Rite Aid locations is because Walgreens is merging with it, and therefore, they assume it must be good. I see it as reminiscent of Exxon buying a fertilizer company in the late 1980s, and then Texaco and Cass Oil following suit because “Exxon must know where the industry is heading”, before all three later quietly closed their fertilizer operations.
Also, it will be interesting to see what portion of Rite Aid’s $7 billion debt burden will come with the transaction (this, in effect, could make the deal much worse than paying over a million dollars to land a $27k profit stream). This $950 million purchase will only net them a little over $20 million in current profits. Heck, with that kind of money, they could buy themselves a $65 million stream just by purchasing Royal Dutch Shell stock and sitting on it.
Fred’s acquisition of Rite Aid stores is nothing to applaud. They are dramatically overpaying for an asset that has only grown profits from $87 million in 2003 to $125 million in 2016 while taking on over $4.5 billion in debt and issuing over 500 million shares in the meantime such that Rite Aid’s earnings per shares actually declined from $0.17 per share in 2003 to $0.12 per share now. Rite Aid’s history is filled with excessive leverage, unfavorable equity dilution, unreliable profit growth, and deep flirtations with bankruptcy during times of economic hardship. It is astounding to me that this asset received a valuation of 40x earnings. If Fred’s stock performs well over the next decade, it will be in spite of rather than because of this transaction.