Fitch Maintains Rite Aid's Ratings on Positive Watch

NEW YORK--(BUSINESS WIRE)-- Fitch Ratings has maintained Rite Aid Corporation's (Rite Aid) 'B' Long-Term Issuer Default Rating (IDR) on Rating Watch Positive. A full list of ratings follows at the end of this release.

Fitch placed Rite Aid on Rating Watch Positive following the October 2015 announcement by Walgreens Boots Alliance, Inc. (Walgreens) that it will acquire all outstanding shares of Rite Aid, for $9.00 per share in cash, for a total enterprise value of approximately $17.2 billion, including acquired net debt. This values Rite Aid at almost 14x Fitch's projected 2016 EBITDA of approximately $1.25 billion including a full year of results from its June 2015 of EnvisionRx. Walgreens expects the transaction to close in early 2017, subject to approval by antitrust regulators.

The Rating Watch Positive reflects Walgreen's significant financial strength. Fitch's 'BBB' rating on Walgreens reflects our expectations that leverage (including Rite Aid) could improve to the low-3x by fiscal 2019 from a proforma leverage in the low-4x based on growth in WBA's EBITDA, realization of the expected Rite Aid synergies, as well as use of FCF for debt repayment. The company's $1 billion cost synergy target from this acquisition is predicated largely on improved sourcing, in addition to reducing duplicative costs in the combined entity. Based on visibility into these synergy opportunities, Fitch believes at least $750 million of the $1 billion targeted synergy savings are possible by fiscal 2019, though mitigated by around $400 million EBITDA reduction, assuming the FTC mandates approximately 1,000 store divestitures due to local market share concerns.

Walgreens will finance the deal with existing cash, new debt issuance and assumption of existing RAD debt. Fitch estimates Walgreens will fund the acquisition with $14.6 billion of debt. Of the $7.3 billion in outstanding Rite Aid debt, Walgreens will pay off $5 billion and assume $2.3 billion of unsecured debt, which is made up of the $1.8 billion notes due 2023, $295 million notes due 2027 and $128 million notes due 2028. Walgreens has obtained $6 billion in term loans and $6 billion of unsecured notes to fund the acquisition.

KEY RATING DRIVERS

Improved Retail Network

The merger will create the dominant U.S. drugstore network of approximately 13,000 stores with a U.S. sales base of $115 billion (Walgreens Retail Pharmacy USA division plus Rite Aid consolidated sales, including EnvisionRx), prior to any potential FTC-mandated divestitures. There are about 13 states, primarily located in the East Coast and California where the companies each operate about 3,000 stores and have sizeable overlap that could see antitrust concerns. Fitch has modelled 1,000 FTC mandated divestitures in its projections. Longer term, the company could continue to rationalize the store base further to consolidate market share and improve profitability.

Rite Aid would improve Walgreens' national retail coverage, particularly in Southern California and Northeastern U.S. markets, positioning it well to compete for inclusion in narrow and preferred pharmacy networks. At the end of Walgreens' fiscal 2015 (ending Aug 2015), 76% of U.S. households operated within a five-mile radius of a Walgreens or Duane Reade (also owned by Walgreens) and Fitch anticipates the coverage is likely to rise to the mid-to-high 80% range at the close of the acquisition.

Update on Rite Aid's Retail Business on Stand Alone Basis

Fitch expects Rite Aid's EBITDA before the contribution from EnvisionRx to be $1.0 billion - $1.1 billion in 2016 and potentially below $1 billion in 2017. This compares to $1.3 billion in 2015.

Rite Aid's pharmacy comps slowed considerably beginning 2Q15 from 4%+ over the prior two years as the company began to cycle the prior year's strong Medicaid expansion benefit. Pharmacy script count was negative 2% in 2Q16 versus being relatively flat over the prior four quarters given pressure on the Med Part D business. The reimbursement rate cuts continue to pressure gross margin and Fitch expects retail gross margin to decline 25 - 50 bps annually over the next 2 - 3 years. Front end sales have been flat to modestly positive as the company has dedicated increased capex toward store remodels and some store relocation activity. As a result, Fitch expects same-store sales to be negative 1.5% in 2016 and flat to modestly negative in 2017.

Update On EnvisionRx

Rite Aid's acquisition of EnvisionRx, an independent full-service pharmacy benefit management (PBM) company, closed in June 2015 and has since generated a full year of business, producing $6.3 billion in revenues and approximately $160 million in adjusted EBITDA for the LTM period ended Aug. 27, 2016. Fitch views this acquisition 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 was supported by Rite Aid's improved credit metrics and cash flow profile over the preceding 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. Fitch expects EBITDA from EnvisionRx could potentially double over the next five years on additional contract wins and growth in its specialty business.

KEY ASSUMPTIONS

--Rite Aid's EBITDA before the contribution from EnvisionRx is expected to be $1.0 billion - $1.1 billion in 2016 and potentially below $1 billion in 2017. Same store sales of negative 1.5% in 2016 and flat to modestly negative in 2017. Retail gross margin is expected to remain under pressure due to reimbursement rate cuts in the pharmacy business.

--EnvisionRx is projected to have 2016 revenues of approximately $6.1 billion and EBITDA in a range of $180 to $200 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.

--Fitch expects FCF to be close to $200 million in 2016 and $100 million in 2017. Leverage is expected to be in the mid 6x over the next 24 - 36 months.

RATING SENSITIVITIES

Fitch would expect to upgrade Rite Aid's existing debt to the 'BBB' category assuming the merger closes as contemplated. If the merger is terminated, future developments that may, individually or collectively, lead to a positive rating action is 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 reduce adjusted debt/EBITDAR towards the mid-5.0x range.

Negative Rating Action: A negative rating action, without the acquisition, could result from deteriorating sales and profitability trends that take leading to negative FCF and leverage towards 8x.

LIQUIDITY

Rite Aid had total liquidity of $1.4 billion as of August 27, 2016, consisting of $136 million in cash and $1.3 billion of revolver availability. Fitch expects FCF to be close to $200 million in 2016 and $100 million in 2017.

RECOVERY CONSIDERATIONS - for Rite Aid on Standalone Basis

The issue ratings below 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 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 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 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.

FULL LIST OF RATING ACTIONS

Fitch maintains Positive Watch on the following ratings:

Rite Aid

--Long-Term IDR 'B';

--Secured revolving credit facility and term loans 'BB'/'RR1';

--Guaranteed Senior Unsecured Notes 'B'/'RR4'

--Non-guaranteed senior unsecured notes 'CCC+'/'RR6'.

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 $38 million in non-cash stock-based compensation and $42 million in other restructuring charges to its EBITDA calculation in 2015.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Additional Disclosures

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1013735

Endorsement Policy

https://www.fitchratings.com/regulatory

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Source: Fitch Ratings

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