Rite Aid (NYSE:RAD) has had an incredible run-up since the beginning of 2013, increasing roughly 5-fold from $1.36 to $6.52, as of yesterday's closing price. At one point, after almost $1 billion in combined losses in 2011 and 2012 (source: RAD 10K SEC filing), the retail drug store chain was in serious danger of bankruptcy. After a solid year of positive quarterly earnings and cash flow from operations as well as a stronger balance sheet, bankruptcy seems to be off the table in the near term. The question for anyone fortunate enough to be holding RAD for more than 6 months is whether to take the money and run or hold on for potential future gains.
I have been following this company for quite some time now and due to the company's recent flirtation with bankruptcy, traditional valuation metrics such as PE ratio, PEG, dividend yield and price to book value, are either not relevant or require a lot of speculative assumptions. As a result, I have prepared a valuation model based on a price-to-EBITDA analysis to determine an estimate of RAD's potential appreciation for 2014 and 2015. This metric provides a baseline to measure future results and the potential stock price impact.
The following table shows an EBITDA comparison between RAD, Walgreen (WAG) and CVS (NYSE:CVS):
|3/24/14 Closing price-||$6.52||$64.31||$74.35|
|Less tangible BV* -||-2.7||17.3||1.9|
|Market capitalization net of tangible BV -||9.0||43.8||85.8|
|Price to EBITDA-||6.9||8.8||8.8|
|Source Yahoo Finance|
|*BV=Most recent quarter, EBITDA trailing 12 Months-RAD & WAG as of 11/30/13, CVS as of 12/31/13; RAD=negative BV|
As the table shows, RAD sells at a discount, even after factoring in tangible book value. This is not unusual and is justified - companies with strong, growing EBITDA and balance sheets deserve a premium and those that don't have these strengths sell at a discount. Based on consistent historical results and the strength of their balance sheets, WAG and CVS certainly deserve to be selling at a higher EBITDA multiple than RAD.
RAD has been executing on its turn-around strategy and the retail drug industry has several tailwinds that foretell continued operational improvements for RAD. The following highlights the positive factors that should enable RAD to continue posting favorable results:
- Ongoing positive quarterly operating results: RAD's fiscal Q3, 2014 results showed another quarter of profits and positive cash flow, the company lowered interest expense by $25 Million in Fiscal Q3, 2014 vs Q3, 2013. The company plans to continue converting 400+ stores annually to its' new wellness concept store. On Rite Aid's most recent quarterly analyst conference call, management noted that these stores comparative sales results were better than the traditional non-wellness stores.
- Fiscal Q4-2014 sales increase: Total drug store sales for the most recent quarter increased 2.2%; this is after negative sales offsets from increased generic sales and 36 less stores at fiscal year-end 2014 vs. 2013. This was the highest quarterly sales for fiscal 2014 and should translate to another profitable quarter, when results are released on April 10th.
- McKesson distribution agreement extended to 2019: This agreement will drive cost savings, inventory reductions and free-up additional cash flow. This agreement includes delivering Rx inventory direct to stores on a daily basis - closely resembling a "Just-In-Time" inventory model that should allow for leaner inventory levels.
- Positive industry trends: The Healthcare Reform Act, which just started enrolling millions of newly insured Americans will enable more people to afford Rx drugs. An aging US population which will drive increased Rx utilization. The on-going trend of branded drugs going off-patent and replaced by generic competition which have higher gross margins.
All of these positive developments should enable RAD to increase EBITDA 15-20% annually for the next 2 years. The company is committed to strengthening its balance sheet, which will help the EBITDA valuation as well.
The following table shows my forecast for EBITDA, net tangible BV and price forecast for 2014 and 2015:
|Price forecast -||$6.52||$10.00||$14.00|
|Market capitalization -||6.3||9.9||13.9|
|Less tangible BV** -||-2.7||-2.3||-1.8|
|Market capitalization net of BV -||9.0||12.2||15.7|
|EBITDA 20% growth**-||1.3||1.6||1.9|
|Price to EBITDA -||6.9||7.6||8.3|
|Forecast appreciation -||53.4%||40.0%|
|Source Yahoo Finance *price as of 3/24/14|
|**BV and EBITDA -trailing 12 months as of 11/30/2013|
My valuation assumptions include: a 20% increase in EBITDA, 25% of total EBITDA in 2014 & 2015 used to increase RAD's book value (net of depreciation) and an increase in the price-to EBITDA multiple. This increased multiple will still be at a discount compared to WAG and CVS. As the chart shows, I am predicting 50%+ appreciation in 2014 and 40% in 2015 - which is more than double the current stock price. I am very optimistic that this is an achievable price target, based on the current operational progress.
There are always risks and obstacles that a wise investor will need to weigh and balance against the positive factors I have noted. Potential risks and obstacles include the following:
- RAD still has a weak balance sheet ($-2.7 Billion) that is not able to withstand any long protracted downturns in its' operating results.
- Management must continue to execute on its current turnaround strategy to achieve the projected results.
- Healthcare reform which adds millions of insured individuals, also adds regulation and makes profound changes to the healthcare delivery model. In the long-term, healthcare reform poses a risk if management does not navigate the changing healthcare industry adequately.
In a market where many analysts are concerned about overall valuation levels being too high, I believe Rite Aid's stock price represents an attractive investment opportunity with plenty of upside. The operational improvements should continue to propel the stock price higher and provide an exceptional return for the next 2 years.
Disclosure: I am long RAD with no intention to sell in the near term. 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.