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Rite Aid Corporation (NYSE:RAD), a $2.6 billion market capitalization company, is a speculative bet in the highly competitive retail drugstore industry. RAD competes against direct competitors, like the much larger CVS Caremark (NYSE:CVS) and Walgreen Company (WAG), and a myriad of other companies, including retailing giants Target Corp. (NYSE:TGT) and Wal-Mart Stores, Inc. (NYSE:WMT). The following table shows some basic statistics for the industry's three retail chains:

Drugstore Companies

Ticker

Name

June 21 Price ($)

Market Capitalization ($ B)

Enterprise Value ($ B)

Implied Leverage

RAD

Rite Aid Corporation

2.86

2.6

9.1

3.5x

CVS

CVS Caremark Corporation

57.57

70.4

80.6

1.1x

WAG

Walgreen Company

48.71

46.2

51.5

1.1x

Source: Yahoo!Finance, Author calculations. Values are from June 21, 2013.

RAD is substantially smaller than either of its two direct competitors, which are both dwarfed by WMT. RAD also has substantially more leverage than either CVS or WAG. RAD and WAG are primarily retailers focused on retail operations. WAG also has about 371 health and wellness facilities. While CVS has a large retail operation, it derives approximately half of its revenue from a pharmacy services segment:

...a full range of pharmacy benefit management ("PBM") services including mail order and specialty pharmacy services, plan design and administration, formulary management, discounted drug purchase arrangements, Medicare Part D services, retail pharmacy network management services, prescription management systems, clinical services, disease management services and pharmacogenomics. - CVS March 31, 2013 10-Q

These additional services are provided to a range of customers including employers, unions, insurance companies, and health benefit plan sponsors. In addition, CVS also runs almost 700 MinuteClinics, almost all of which are located within its retail stores.

One final note is that the fiscal year for RAD ends in late February/early March, while it is August for WAG and December for CVS. In comparing annual figures, I'll measure against the predominant calendar year, so 2012. Hence, 2012 refers to RAD's fiscal year ending in early 2013.This provides a good comparison between RAD and CVS; however, WAG and RAD have less than 6 months of actual overlap.

RAD has a smaller geographic footprint

All three firms are national in scope; however, only WAG is in all 50 states plus Washington D.C. RAD covers just 31 states and Washington D.C. Both CVS and WAG are expanding beyond the fifty states with additional operations in Brazil and Puerto Rico and Guam. Despite a much smaller market capitalization, RAD does not have proportionally fewer stores. RAD has 4,623 retail stores, while CVS has 7,531 stores. WAG has 8,537 facilities (including 8,072 retail locations). The following table compares the most recent quarterly sales for retail stores.

Per Store Revenue

Ticker

Retail Locations

Q1 2013 Revenue ($ Millions)

Per Store Revenue Annualized ($ Millions)

RAD

4,623

6,455

5.6

CVS

7,531

16,051*

8.5

WAG

8,072

18,647

9.2

Source: RAD March 3, 2013 10-K, CVS March 31, 2013 10-Q ,Yahoo!Finance, WAG February 28, 2013 10-Q *Only Retail Pharmacy Segment revenue is included. Annualization is the most recent quarter multiplied by 4. Recent quarter ends were March for RAD and CVS and February for WAG.

RAD's Operating Performance lags its Competition

The following analysis will focus on the operating performance of these stores through a range of metrics. First, I'll look at the cash conversion cycle for RAD. The cash conversion cycle is a measure of how quickly a company gets cash from customers, pays suppliers, and keeps cash in the form of inventory. The following table details these three components for RAD:

Cash Conversion Cycle

Factor

2012

2011

2010

Days of Inventory

63.5

59.5

62.2

Days of Receivables

14.0

13.8

14.0

Days of Payables

50.8

45.8

46.5

Cash Conversion Cycle

26.7

27.5

29.8

Source: RAD Financials from Yahoo!Finance Income Statement, Balance Sheet, Author Calculations

The good news is that RAD's cash conversion cycle is improving. This improvement is from stretching its payables despite a slight increase in days of inventory. The following table shows the comparison of the three stores for cash conversion cycle.

Cash Conversion Cycle (days)

Ticker

2012

2011

2010

RAD

26.7

27.5

29.8

WAG

10.5

12.3

12.9

CVS

27.6

33.0

38.1

Source: RAD Financials from Yahoo!Finance Income Statement, Balance Sheet, WAG Financials from Yahoo!Finance Income Statement, Balance Sheet, CVS Financials from Yahoo!Finance Income Statement, Balance Sheet, Author Calculations

While all companies are improving, WAG is a clear leader and CVS has shown the largest improvement, shaving over 10 days off its 2010 figure. Due to business differences, RAD's target should be WAG. The following table shows the days of inventory for the past two years for each of these companies.

Days of Inventory

Ticker

2012

2011

RAD

63.5

59.5

WAG

53.7

54.4

CVS

37.7

43.7

Source: RAD Financials from Yahoo!Finance Income Statement, Balance Sheet, WAG Financials from Yahoo!Finance Income Statement, Balance Sheet, CVS Financials from Yahoo!Finance Income Statement, Balance Sheet, Author Calculations

This table shows a clear advantage to CVS; however, it is an overall company figure that includes its Pharmacy Benefits Segment as well as the retail segment.

In comparing asset turnover, I'll highlight an important consideration. Asset turnover is the ratio of revenue to average total assets during that time period. It is one measure of capital productivity, but should also be noted that revenue is the highest level metric. The following table compares the several years for asset turnover.

Asset Turnover

Ticker

2012

2011

2010

2009

RAD

3.5

3.5

3.2

3.1

WAG

2.4

2.7

2.6

2.7

CVS

1.9

1.7

1.5

1.6

Source: RAD Financials from Yahoo!Finance Income Statement, Balance Sheet, WAG Financials from Yahoo!Finance Income Statement, Balance Sheet, CVS Financials from Yahoo!Finance Income Statement, Balance Sheet, Author Calculations RAD 10-K, CVS 10-K, WAG Annual Report

RAD appears to have the best asset turnover ratio among the three companies. Furthermore, this ratio has been increasing since 2009. However, this ratio can be misleading. First, RAD has reduced its total book value of assets through write downs, thus inflating the ratio. RAD also makes substantial use of operating leases, something that WAG does not. These same operating leases would also mean that the implied leverage for RAD in the first table is understated. Furthermore, this analysis uses book values, which may be very different from the true market value of those assets. Heavily depreciated assets may give rise to higher book metrics, but if the actual asset is also older, the true productivity and market value might be less.

Revenue Mix does not Distinguish RAD

When comparing retail operations, understanding product mix is critical. If the product mixes are comparable, then one can more readily draw conclusions about margins. However, if there were significant differences in product mix, there might then be corresponding differences in profitability independent of management decisions and strategy. The following table first shows the revenue mix by category for RAD:

RAD Revenue Mix (Percent of Total)

Category

2012

2011

2010

Prescription drugs

67.6

68.1

67.8

Over-the-counter medications and personal care

9.9

9.8

9.8

Health and beauty aids

5.2

5.2

5.2

General merchandise and other

17.3

16.9

17.2

Source: 2013 RAD 10-K

This revenue mix is almost identical to that of CVS and they use essentially identical category names.

CVS Retail Revenue Mix (Percent of Total)

Category

2012

2011

2010

Prescription drugs

68.8

68.3

68

Over-the-counter and personal care

10.8

10.9

10.9

Beauty/cosmetics

5

5.2

5.1

General merchandise and other

15.4

15.6

16

Source: 2012 CVS 10-K, Revenue mix reflects only the retail operations of CVS

WAG derives relatively less revenue from Prescription Drugs and a little more on general merchandise as noted in the following table.

WAG Revenue Mix (Percent of Total)
Category201220112010
Prescription Drugs636565
Non-prescription Drugs121010
General Merchandise252525

Source: WAG 2012 Annual Report

WAG has a slightly lower portion of its revenue from prescription drugs and more emphasis on general merchandise than either RAD or CVS. The similarities in revenue mix suggests that we can be more confident in making comparisons across margins. The other observation is that these values have been relatively stable over the past three years for all three companies.

Profitability is a Key Difference Among the Companies

While the highest level of revenue mix does not distinguish RAD from its competitors, there are additional nuances to consider. First there are breakdowns with the revenue categories that impact profitability. It is possible to lose revenue and gain profit. At first glance this might not make sense intuitively, but the WAG SEC filings clarify:

In general, generic versions of drugs generate lower total sales dollars per prescription, but higher gross profit margins and gross profit dollars, as compared with patent-protected brand name drugs. The positive impact on gross profit margins and gross profit dollars typically has been significant in the first several months after a generic version of a drug is first allowed to compete with the branded version, which is generally referred to as a "generic conversion." - Walgreen Company February 28, 2013 10-Q

Gross margin is the highest level of profitability that can be used to compare companies. The following table shows that RAD has a favorable gross margin when compared to WAG and at first glance when compared to CVS.

Gross Margin
Ticker201220112010
RAD28.8%26.0%26.5%
WAG28.4%28.4%28.1%
CVS18.3%19.2%21.1%

Source: RAD Financials from Yahoo!Finance Income Statement, WAG Financials from Yahoo!Finance Income Statement, CVS Financials from Yahoo!Finance Income Statement, Author calculations

RAD's gross margin has been trending upwards. CVS's low gross margin is due to the combination of its retail and services segment. In the most recent quarter, its retail segment posted a stunning 30.9% gross margin, while the services segment posted a lowly 4.2%. So while RAD's figure is slightly better than WAG's gross margin, it still trails CVS on this metric. WAG is probably underperforming on this metric, especially given its larger scale and presumed greater purchasing power with suppliers.

Operating Margin
Ticker201220112010
RAD2.5%0.6%0.1%
WAG4.8%5.4%5.1%
CVS5.9%5.9%6.4%

Source: Source: RAD Financials from Yahoo!Finance Income Statement, WAG Financials from Yahoo!Finance Income Statement, CVS Financials from Yahoo!Finance Income Statement, Author calculations

One can see that despite, RAD's solid gross margin, it has a much lower operating margin, lower than either CVS or WAG. Furthermore, CVS's operating margin is even understated since the 5.9% is for the entire business. Their actual margin for the retail segment in the most recent quarter was around 10%, while the services segment lagged with just a 3% operating margin. The positive news is that RAD is improving, while WAG and CVS show slight declines.

Increasing the operating margin will be critical to RAD's long-term success. While RAD has some nonrecurring expenses, these only represent 0.3% of revenue. The critical issue is its SG&A expense, which is much higher than either competitor as the following table shows:

SG&A to Revenue (Percent)
Ticker201220112010
RAD26.0%25.0%25.6%
WAG23.6%22.9%23.0%
CVS12.4%13.3%14.7%

Source: RAD Financials from Yahoo!Finance Income Statement, WAG Financials from Yahoo!Finance Income Statement, CVS Financials from Yahoo!Finance Income Statement, Author calculations

This shows the gap between RAD and WAG quite clearly; it also highlights CVS's ability to drive down its SG&A relative to revenue by growing revenues at a faster pace than SG&A. RAD's SG&A is also trending in the wrong direction.

Net Margin
Ticker201220112010
RAD0.5%-1.4%-2.2%
WAG3.0%3.8%3.1%
CVS3.1%3.2%3.6%

Source: RAD Financials from Yahoo!Finance Income Statement, WAG Financials from Yahoo!Finance Income Statement, CVS Financials from Yahoo!Finance Income Statement, Author calculations

RAD is showing the right trend especially in light of the declines posted at CVS and WAG; however, it still has a long way to go. RAD appears to not lose much additional ground between Operating Margin and Net Margin relative to WAG. While it has substantially higher interest expense than WAG and CVS (2.0% of revenue vs. 0.1% for WAG and 0.5% for CVS), it has been recognizing some tax benefits that creates an offset.

If RAD can improve its net margin through reductions in SG&A, shareholders would benefit. This is also one of the key differences with its competitors.

Key Valuation Metrics Show RAD Faces Challenges

While RAD faces a host of challenges, the question is always what might be a good price for this stock. The first question is figuring out an appropriate discount rate. Looking at equity, RAD has a 1.6 beta (higher than either CVS at 1.0 and WAG at 1.4) which in combination with the recent 2.5% yield on the ten-year Treasury bond and a 7% equity risk premium implies a required equity hurdle rate of 13.7%. This is quite high for a stock, but one should note that RAD is heavily leveraged and that debt, even at 9.25% cost, will help lower the overall discount rate. In comparison, WAG has an equity hurdle rate around 12%, but also very little debt.

Another key consideration is growth. One can look at this from multiple angles including top line (revenue) growth, EPS growth, net income growth, or cash flow growth. Analysts are projecting modest revenue growth from $25.4 billion to just $25.6 billion by the year ending February 2015. In contrast, WAG is expected to climb from $71.6 billion to $75.8 billion for the year ending August 2014. CVS is expected to climb from $123.1 billion to $130.6 billion for the year ending in December 2014. However, RAD is projected to show meaningful future EPS growth from $0.16 to $0.25, but only because the $0.16 is a drop from the TTM value of $0.24, so much for that growth. Both WAG and CVS are expected to have EPS growth around 10% in the near term and a little higher over the next five years. RAD trails both with a five-year EPS growth estimate around 8%.

Combining the growth and discount rates with historical financials and analyst projections can be used to develop a basic discounted cash flow model to examine various assumptions and scenarios. Under the present cost structure, growth, including the perpetuity growth rate, would have to reach approximately 5% to justify RAD's existing price. Based on near-term projections, this seems pretty unlikely. Hence, the value and potential upside would have to reflect margin improvements. Using a more modest 2.5% growth rate, one would have see operating margins climb to 4.5% over time to justify the current value. Hence, meaningful upside would require RAD to eventually pass WAG's operating margin of 4.8%. Given the industry outlook, this may be quite challenging.

Comparing multiples can provide some insights, but is especially challenging given the key differences across this sector - CVS has a significant other business and RAD carries significant operating leases relative to WAG. However, the following table summarizes a range of values:

Valuation Multiples
TickerTTM P/EEnterprise Value/EBITDA
RAD11.96.8
WAG21.78.4
CVS17.910.9

Source: Capital IQ through Yahoo!Finance for RAD, WAG, CVS

These multiples clearly show that investors value RAD's underlying financials at a lower level than its competitors, most likely due to the lower growth. While there are a wide range of factors, including growth and discount rate that can impact these differences, an investor should not look at RAD as having upside from multiple expansion. The lower multiples are a result of lower growth, both historical and projected. Any increase in the multiple would have to be preceded by significant improvements in underlying performance.

Even if the Valuation Worked, RAD still faces Numerous Risks

An investment in RAD would not be without significant risks. Risks can be thought of in several categories. The first group would be company specific risks. The second group would be industry risks and it is possible for industry risks to disproportionately impact different companies. The third category would be broader market risks (e.g., economy, interest rates). This section will focus primarily on the first group of risks and touch on the second.

  1. Competition - The retail drugstore business is highly competitive and RAG has a significant scale disadvantage relative to its direct competitors. This is true for all participants but should disproportionately impact smaller members. One should also note that RAG's gross margin is comparable to WAG showing that it appears to be getting similar types of prices from suppliers or has a more favorable product mix.
  2. Healthcare Industry transformation - there are a range of changes in the healthcare industry that could adversely impact the retail drugstores. RAD notes industry consolidation as one of its key risks. Furthermore, recent legislation could also significantly impact RAD and other industry participants.
  3. Leverage - RAD has a substantial debt burden. During fiscal 2013 which includes ten months of calendar 2012, RAD completed two debt financings. Furthermore, its interest expense has declined slightly in the past couple of years. RAD has $8.6 billion in long term debt as well as $8.3 billion in operating lease obligations. Its recent debt has been issued at 9.25%.
  4. Performance improvement - any long position on RAD has to make significant assumptions about its ability to continue to expand margins
  5. In-store experience - this is a more subjective assessment and difficult to divine from the financials and other materials readily available. There is a key question of whether RAD is providing an improving customer experience or not. At the end of the day, RAD has to attract customers into these stores to purchase their prescriptions and hopefully some other goodies as well. This will also go a long way towards retaining business acquired from the resolution of WAG/Express Scripts dispute.

Bottom Line

RAD might have some significant upside potential, but it also has significant risks as well. While its PE ratio appears to be attractive, its growth still trails that of its competitors. Its high leverage is further reason that it should trade at a discount to its peers. At this point in time, I could not recommend RAD beyond being a speculative turnaround bet. Even to make that bet, one would have to believe that RAD can deliver significant and sustainable performance improvement across a broad number of dimensions. The key analysis would be to determine how RAD will add 2.5%+ to its operating margins and convince yourself that it is possible. The secondary analysis would be to take a deeper look at RAD's liabilities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Source: Rite Aid: Competing With Giants