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Rite Aid (RAD) holds the position of third largest drug retailer with a network of approximately 4,600 drug stores in 31 states. Over the past five years, the company has witnessed profits for the first time in fiscal year 2013, and this positive trend of generating profits continued in the first quarter of 2014 too. Currently, Rite Aid is adopting various strategies to attract customers toward its stores, which is expected to enhance its top line. As far as its stock price is concerned, in the past six months it has increased by 88%.

President Obama signed the Affordable Care Act in 2010 and the Supreme Court gave acceptance to it in 2012. With the roll out of many provisions of this law, over 100 million people have already benefited from it, and this act will be fully implemented in 2014. Currently, the act is expanding Medicaid, which is about providing insurance and healthcare facilities to lower income American residents. This will be effective in January 1, 2014, which is expected to act as a growth driver for drug retailers, as American residents will be filling more drugs prescriptions with enhanced health insurance coverage. With this, analysts are estimating that 5 million to 12 million Americans will enroll in various health insurance benefits over the next five months.

To capitalize on this scenario, Rite Aid is taking various initiatives to attract customers toward its stores.

Rite Aid plans to remodel approximately 1,200 stores by the end of fiscal year 2014, and it has remodeled 1,019 stores by the end of third quarter 2014. These remodeled stores, known as Wellness stores, are different from its traditional stores. Key features of Wellness stores comprise of a private pharmacist room, which will allow customers to receive a medical checkup in the stores, and it includes a new health books and magazines section for customers. In its third quarter updates, these 1,019 Wellness format stores have already witnessed an improved performance on an account of better same store sales than Rite Aid's traditional stores as more customers are attracted towards its Wellness format stores. Comps at Wellness stores exceeded by 3% as compared to its traditional stores. With the completion of its plan, 1,200 remodeled stores are expected to witness the same revenue growth as these they are posting currently.

Peer comparison

Walgreen (NYSE:WAG) has the largest network of drug stores in the U.S. with 8,300 stores, followed by CVS Caremark (NYSE:CVS) being second with 7,601 stores. Over the last 11 quarters, with its various strategies, EBITDA of Rite Aid has witnessed growth. The company has a trailing twelve month EV/EBITDA ratio of 4.36. It has reduced significantly over the past five years, implying that the company has generated a greater proportion of earnings than capital invested in the company. Rite Aid's earnings are expected to grow by 42.36% year over year by the end of fiscal 2014, which will further improve its valuation multiples.

On the other hand, Walgreen has a trailing twelve month EV/EBITDA of 11, which has increased from 7.85 in 2008. Although Walgreen is adopting various strategies to increase its earnings, previous disputes between Walgreen and its pharmacy benefit manager ExpressScripts has affected its earnings. As far as its next year's earnings are concerned, it is expected to grow by 13.82% by the end of 2014.

CVS Caremark's trailing twelve month EV/EBITDA is 8.57, which has slightly reduced from 8.78 in 2008. CVS Caremark is set to benefit from the Affordable Care Act as this is the only drug retailer having its own pharmacy benefit management. With this, its next year's earnings are expected to grow by 12.36%.

Rite Aid, being the third largest drug store operator of the U.S., has the lowest EV/EBITDA ratio in this industry with a ratio of 4.36. This implies that Rite Aid is currently trading below its fair value, being an undervalued stock with potential for higher earnings growth next year.

Stock valuation

EBITDA estimates:

Fiscal Year

EBITDA (In million $)

2011 (Actual)

859

2012 (Actual)

942.9

2013 (Actual)

1,128

2014 (Estimated)

1,293

Over the past three years, the EBITDA of Rite Aid has improved by 14.69% on average, which has supported the company to report profits for the first time in 2013. With this growth rate, the company has witnessed profits for the past four consecutive quarters. Taking 14.69% as a growth rate, I am anticipating its EBITDA to surge to $1.29 billion for fiscal year 2014, impacting its profits going forward.

In fiscal year ending 2013, Rite Aid's EV/EBITDA valuation multiple is at 9.5, and expected EBITDA for the fiscal year 2014 is $1.29 billion. With these multiples, its enterprise value is expected to be $12.28 billion for fiscal year-end 2014. At present, the company has net debt of $5.9 billion with cash and its equivalents of $144 million. Assuming net debt ($5.9 billion) and cash ($144 million) to remain constant for the next year, I anticipate its expected market capitalization would be $6.52 billion by the end of 2014. Currently, Rite Aid has approximately 918 million outstanding shares, and with the assumption that these outstanding shares to remain constant, its stock price target is expected to be $7.10 by the end of fiscal year 2014. Currently, Rite Aid's stock price is trading around $5.26, therefore, there is upside potential of approximately 35% from the current stock price level.

Source: Rite Aid: 35% Upside Is Possible