Stock Market

Last week, meme investors “discovered” Rite Aid (NYSE:RAD), sending its shares up 70%. The Wall Street Journal would quickly give the company a meme stock crown.

For most traditional investors, Rite Aid looks like a terrible bet. The struggling drug retailer hasn’t been profitable since 2017, and a deal five years ago to sell 1,932 stores to Walgreens (NASDAQ:WBA) left the chain with some of its less profitable stores. Rite Aid generates only $10 million per store in annual revenues, a third lower than Walgreens.

But try telling that to a meme investor. To them, Rite Aid looks like a highly shorted equity that could rise 5X… or even 10X in a matter of months.

Already, speculators are snapping up out-of-the-money options — high-risk bets that occasionally pay off handsomely. And as interest in RAD stock mounts, don’t be surprised if this failing retailer suddenly becomes the next meme.

Rite Aid: What Makes a Meme Stock?

Meme stocks are loosely defined as speculative stocks that have gained viral popularity on social media.

Some of these firms are compelling bets with solid cash flows. Fast food chain Wendy’s (NASDAQ:WEN) briefly became a meme stock in 2021; the firm continues to generate plenty of growth today. Other bets are less healthy. Millions of Bed Bath & Beyond (OTCMKTS:BBBYQ) shares continued to change hands, even after the bankrupt retailer dropped into the over-the-counter (OTC) markets.

But meme stocks all share a popularity that goes beyond ordinary money-making endeavors. To investors in these popular stocks, buying shares is often the price of admission into a community of like-minded investors.

That means most meme stocks are widely recognizable companies. Retailers like AMC Entertainment (NYSE:AMC) and GameStop (NYSE:GME) have extensive physical footprints. Visit any major U.S. city, and chances are good you’ll drive past one of their stores. And virtually all meme stocks follow easy-to-understand investment themes, such as electric vehicles, bankruptcies, and deep value.

That makes Rite Aid a particularly irresistible target for meme stardom. The 60-year-old firm has roughly 2,213 stores scattered across the U.S. and a seemingly straightforward business model that’s mostly easy to grasp. Its balance sheet also provides incredible upside if things go right.

Rite Aid’s Hidden Upside

On a practical level, Rite Aid’s shares have unusually large upside. All else equal, every 1% increase in Rite Aid’s enterprise value mathematically raises its market capitalization by 21.8%. That makes both its stock and options a potentially explosive play.

Four other sources of leverage further boost potential returns.

First, the firm has large financial debts. According to data from Thomson Reuters, Rite Aid’s $224 million on debt service payments in fiscal 2023 pegs its cost of long-term debt at 16%. That’s far higher than its estimated 7.4% cost of equity and means every dollar the company can put toward debt extinguishment will tremendously impact profitability.

Second, Rite Aid also carries a lot of physical debt. Since 2016, the firm has spent only $1.2 billion on the purchase of fixed assets — money used on renovating stores, warehouses and other tangible assets. That’s about $700 million shy of its depreciation charges in that period, and why most Rite Aid stores look far older than their peers.

Third, the drug retailer has potential legal debt. In March, the U.S. Justice Department filed a lawsuit against the company for allegedly filling illegal opioid prescriptions. According to the lawsuit, Rite Aid “knowingly filled unlawful prescriptions for controlled substances” between May 2014 through June 2019. A similar case against Walmart’s (NYSE:WMT) pharmacies in 2022 resulted in a $3.1 billion fine.

Finally, Rite Aid has a great deal of supplier debt. In July, the company reported it had $1.5 billion in accounts payable — more than its gross profits during an average quarter. That magnifies Rite Aid’s return on capital invested (ROIC) and creates another form of financial leverage.

That gives the drug retailer an enormous amount of hidden leverage. Although the likeliest outcome is eventual bankruptcy, even minor improvements in the company’s fortunes can have a knock-on effect on its worth.

Rite Aid: Becoming a Meme Stock

This fact isn’t lost on meme investors. On Monday, the open interest of short-dated $4 options doubled as investors began wagering that shares would continue going up. These are some of the riskiest bets that ordinary traders can make, since most short-dated options expire worthless.

Volumes traded have also risen to absurd levels. Last Wednesday, 57.2 million Rite Aid shares changed hands, up from 778,000 the week before. The company only has 56.7 million shares outstanding.

Other meme stocks have also begun to pick up steam. The Roundhill MEME ETF (NYSEARCA:MEME), a broad-based meme stock ETF, is up 8% in the past month. Ordinarily, rising meme stocks create a “wealth effect” among investors, causing even greater risk-taking.

That suggests RAD stock could rise higher on a broad meme rally. Its 23% short interest — and high leverage — makes it a candidate for a squeeze.

That’s excellent news for Rite Aid shareholders. A share spike would help the firm refinance and reduce its costly debts. Rite Aid can issue another 18.3 million shares without increasing its authorized share cap. A cash influx could also help fund more extensive renovations, making its physical stores more competitive with profitable dollar stores. Many of Rite Aid’s ills are curable with cash.

Where Will RAD Stock Go?

Of course, an investment in Rite Aid stock comes with plenty of risks.

The most obvious is that shares go to zero. The firm remains solidly unprofitable, and analysts believe that operating losses will continue through at least 2026. A 3-stage DCF model shows that shares are worth zero.

Corporate management also remains in a funk. An interim CEO has headed the firm since January, and finding a qualified replacement has proved difficult.

Most importantly, investors face getting caught up in a meme frenzy that goes nowhere. Many speculators have bought shares of promising meme bets, only to see shares decline. Mullen Automotive (NASDAQ:MULN) has lost 99.9% of its market value since 2021, despite being among the most popular meme stocks on the social media site StockTwits.

Still, history tells us that turnarounds like Rite Aid tend to perform better than expected. And Rite Aid’s underlying business is far from dead; it still makes over 50% of its revenues from prescription drugs and another 25% from pharmacy services — areas with typically high margins. Foot traffic is also reaccelerating. In fiscal 2023, Rite Aid recorded a 6.9% increase in same-store sales growth.

If meme investors do jump on the bandwagon, speculators could expect shares to surge well beyond $5. And for those seeking price action, RAD stock will likely prove too tempting to resist.

As of this writing, Tom Yeung did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.

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