The Right Price for Rite Aid

Shares of drug retailer and my employer Rite Aid (RAD) have been under considerable pressure during the last year, plunging from just below $7/share to their current level near $2/share. Glancing at a 10-year chart of Rite Aid reveals several previous occasions where the stock tanked to around this level, providing investors and traders with the opportunity to earn returns of 2X to 5X their money as the stock subsequently rebounded to the $5 to $10/share level. Whether the current downturn in Rite Aid will provide similar returns remains to be seen, but overall market weakness, economic uncertainties, and a huge increase in the short interest of the Company at the end of December to 56.7 million shares (from 44.4 million in mid-December) suggests that a wait and see approach may be prudent in this downturn. Specifically, I am waiting for a meaningful decline in short interest to a level that is below the average over the last 12 reporting periods (44.5 million shares) and at least a 10% rebound from the 52-week low, which the stock continues to drift around during recent trading.

The most recent sell-off in Rite Aid was triggered by weak, industry-wide same-store sales for December, which declined by 0.5% on flat prescription drug sales and front-end sales that were down by 1.2%. The decline in December same-store sales followed increases in the previous two months of 0.4% for October and 0.9% for November. Drug retailers cited a slow start to the flu season and increased sales of lower-priced generic drugs (which ironically result in higher profit margins) for the poor results. Specifically, an unexpected recall of children's cough and cold medications and anemic demand for seasonal items put a dent in sales for December across the entire industry. Despite concerns over a recession and other economic uncertainties, Rite Aid is poised to capitalize on convenience as it expands several initiatives to improve sales and customer service, including the following: in-store health clinics/services, expanding the number of drive-thru locations, and in-store digital photography services. Also, with pharmacy sales accounting for over two-thirds of total sales and a shift to higher-margin generic drugs, the Company will benefit from demographic trends in an aging population with an increased reliance on prescription drug therapies.

Before the same-store results, Rite Aid dropped from the $4/share level to below $3/share after reporting disappointing 3QFY08 results with a wider than expected loss and a sales shortfall. The Company also lowered its guidance for profitability (or lack thereof with a wider than expected loss of $161 to $192 million now expected from $78 to $161 million), sales ($24.3 to $24.6 billion now expected from $24.5 billion to $25.1 billion), same-store sales growth (1% to 2% growth now expected from previous 1.3% to 3.3%), and EBIDTA ($950 million to $1 billion now expected from previous $1 to $1.1 billion). Rite Aid ended the quarter with 5,089 stores in operation and expects the Brooks/Eckerd acquisition of over 1,850 stores to be fully integrated by the Fall with expected cost-saving synergies of $200 million in FY08 and $300 million in FY09.

CEO Mary Sammons has defended concerns over the Company's liquidity, stating that Rite Aid has a $1.7 billion revolving credit facility with virtually no restrictions and cash/equivalents of $173 million on the balance sheet. Also, the CEO exercised options to buy 200,000 shares of common stock at $2.75 per share in mid-October 2007, bringing her total stake to 1.4 million shares. Looking ahead, the expected cost/operating synergies from the Brooks/Eckerd acquisition, favorable demographic trends, increased sales of prescription/generic drugs, and a focus on customer service/convenience makes Rite Aid a stock to buy once the stock shows signs of recovery from making new 52-week lows and short interest begins to decline below the average of the last 12 reporting periods (44.5 million shares).

For FY09, I believe Rite Aid can achieve EBIDTA of at least $1 billion, resulting in a price target of $5/share based on an enterprise value [EV] to EBIDTA ratio of 10X, which includes about $6 billion in outstanding debt and a market cap of about $4 billion at $5/share for a total EV of $10 billion. The EV/EBIDTA ratio of 10X is in-line with peers such as Walgreens (WAG) at 9.1X, CVS (CVS)at 12.6X, and Longs Drug (LDG) at 7.1X, compared to Rite Aid's current multiple of 12.3X.

Alternatively, Rite Aid could become part of industry-wide consolidation with private equity as the most likely buyer given the leverage of the Company's high debt load and anti-trust concerns associated with an acquisition by industry giants Walgreens or CVS. Also, a point often overlooked is that Jean Coutu Group is now Rite Aid's largest shareholder with about 252 million shares or about one-third of the Company.

However, as part of the transaction for over 1,850 Brooks/Eckerd stores, Rite Aid benefited from an inflated stock price of $4.54 to $4.71 per share, resulting in a deal that included $1.45 billion in cash and $1.1 billion in stock that would not be feasible today with Jean Coutu's stake deflated to a value of just over $500 million. Now, it just remains to be seen whether Rite Aid can capitalize on the deal by effectively integrating the Brooks/Eckerd stores in the form of cost savings, increased sales, and profitability.

Disclosure: Author has a long position in RAD

Comments

[lefty]

Concerns on Rite Aid are very correct. I don't think they are fixable.

[mikehav]

That's why its trading at/below $2/share - much better risk/reward at these levels for investors since the stock is priced like a call option with no expiration date as long as RAD stays in business, which I believe it will.

[User 138320]

I think you are too optimistic in your analysis. You ignore its real estate problems entirely--the unexpected closing of all 28 stores in the Las Vegas metro area, selling Rx to Walgreens, with heavy future lease obligations; the unloading of other stores in the Pacific Northwest; lack of liquidity in the commercial mortgage markets; and questionable location decisions. Visit the stores, and see whether its operations have improved. (I have. They haven't.) You also are silent on the new Medicaid compensation structure for generic drug sales, likely effective Jan 31, 2008, and its domino effect. Plus the cloudy general economic conditions. The last RAD stock price I saw was $1.90 per share. Are there still any buyers left, before bankruptcy?

[mikehav]

Now trading at $2.20 - Let's give it until the end of 2008 and see who is right on this one - Coutu Group is content to view this as a long-term story despite huge losses since B/E deal on the RAD they received.

[ballsschweaty]

I believe Rite Aid will file for bankruptcy in 2009. They are poorly operated, especially on the west coast and they have no financial flexibility to weather a consumer led recession.

This is a much worse situation than Kmart when they filed for bankruptcy.

This is a zero in my opinion.

[Victhom]

Well I guess Someone here forgetto read Q3 with analysts....

CFO Kevin Twomey talks to analysts.....

Ed Kelly - Credit Suisse

In terms of the Eckerd synergies, were the synergies you achieved this quarter in line with what you had expected?

Kevin Twomey

Very much so, Ed.

Ed Kelly - Credit Suisse

Can you give us a sense as to how much of that $200 million has been achieved so far, year-to-date?

Kevin Twomey

As we talked before, because of some of the ramp up, the fourth quarter is not evenly spreads off the three quarters, but we are very, very close to two-thirds of it.

OK 2/3 of $200M=$133M saving in Bank...Copy that ??

Next...

Ed Kelly - Credit Suisse

Kevin, could you just go over the liquidity situation? Whens your next big maturity? Whats under the revolver? What are you expecting in free cash for this year? Do you still expect it to be positive next year?

Kevin Twomey

The required maturities over the next three years are less than $175 million and the largest component of that is the $150 million note thats due December 15, 2008. Basically as we are going through the integration and ramping up the synergies, fiscal 2008 is going to be what everybody refers to as a negative free cash flow. In other words, operating cash flows will be less than the capital expenditures.

But in fiscal 2009, we still expect operating cash flows to exceed CapEx and in fact have us paydown the revolver. So from a, if you will, strategic perspective, from a commitment in terms of keeping things balanced, nothing haschanged. We are, if you will, very, very flexible; we have a lot of flexibility with regards to revolver and there are no restrictions on it.

So we think we are in very good shape, and as I mentioned, we areat our holiday season third quarter inventory build along with the planogram, retrofitting the Brooks/Eckerds, along with the moving out of the non go-forward inventory and restocking adding an additional burden in building inventory. So, we are kind of where we need to be, but that doesnt mean we dont have opportunities. I think that I would be remiss in my duties as a CFO by saying that we arent always looking for ways to improve the investment of our working capital inthe business.

And last....

John Heinbockel - Goldman Sachs

Finally, you sound pretty comfortable with the revolver availability. At this point you dont seethe need to go out and raise permanent capital to be able execute the CapEx program over the longer term? You are happy with the availability on the revolver?

Kevin Twomey

Very much so, John. I mean, we basically established our revolver and with the mix of revolver and term loan and senior notes with the idea in mind that we needed to have a lot of flexibility and a lot of liquidity to support our business plans over the next several years.

I know its inthe back of everybodys mind because the markets areso goofy right now, but we dont have to access the capital market to execute and support our business plan.

[Victhom]

Jean Coutu expects U.S. to boost fortunes

Results plummet 88 per cent, but Quebec-based chain is confident that election focus will put more money into health care
BERTRAND MAROTTE

January 11, 2008

MONTREAL -- Jean Coutu Group (PJC) Inc. is counting on a renewed commitment to health care spending in the U.S. to help boost the fortunes of troubled drugstore giant Rite Aid Corp., which now carries Coutu's hopes for expansion south of the border.

Coutu, which has a 32-per-cent stake in Rite Aid, is confident the third-largest pharmacy chain in the U.S. will get through the current economic slowdown, successfully integrate its new stores and reap benefits from an expected revamping of the U.S. health system, said president and chief executive officer François Jean Coutu.

No matter who wins the U.S. presidential election in November, new money will be invested in health care to extend coverage to a larger part of the population that doesn't have any, Mr. Coutu said in an interview. That, in turn, will help drive sales growth at the pharmacy counter, he added.

He made the comments after Longueuil, Que.-based Coutu revealed that second-quarter profit fell 88 per cent on a big hit from its share of losses at Rite Aid.


Mr. Coutu also said he has full confidence in the ability of Mary Sammons, Rite Aid's chairman, president and chief executive officer, to turn around the chain and successfully integrate the Brooks and Eckerd drugstores it acquired from Coutu last June.

"We've offered feedback and advice from the beginning on the integration. These are not easy times, but we have to be patient," he said.

Coutu has four of 14 seats on the Rite Aid board after closing a $3.9-billion (U.S.) deal last June to sell its U.S. pharmacies to Rite Aid. The transaction included $2.36-billion in cash and 250 million Rite Aid shares, or about 32 per cent of the outstanding stock.

Investors have been growing skittish over Coutu's heavy exposure to Rite Aid, whose stock value has been slashed almost in half over a host of factors, including a weaker-than-expected 2008 outlook and a significant third-quarter loss.

Coutu's second-quarter results - $9.5-million (Canadian), compared with a profit of $79.3-million in the same period last year - include an after-tax loss of $26.1-million or 10 cents a share on its Rite Aid holding.

On a conference call yesterday, Andre Belzile, Coutu senior vice-president for finance and corporate affairs, said there appears to be a market overreaction to what should be a normal period of adjustment as Rite Aid works to integrate the Brooks and Eckerd stores.

"It's really early to make any conclusions on the outcome of the situation."

Both he and Mr. Coutu said the integration is going smoothly.

"I realize Rite Aid is going through an integration process - the economy is not extremely strong south of the border - but this is a long-term investment," Mr. Coutu said on the call.

"Our shareholders should look at it the same way."

[Victhom]

Also ome shorts here forget to tell you that Insiders loading up...and i will prove it to you....

INSIDER TRANSACTIONS REPORTED - LAST TWO YEARS
Date Insider Shares Type Transaction Value*
8-Jan-08 SATRE PHILIP G
Director 96,000 Direct Acquisition (Non Open Market) at $2.10 per share. $201,600

19-Oct-07 SAMMONS MARY F (CEO)
Officer 200,000 Direct Option Exercise at $2.75 - $2.75 per share. $550,0002

5-Oct-07 JEAN COUTU GROUP (PJC) INC.
Beneficial Owner (10% or more) 1,975,262 Direct Purchase at $4.54 - $4.71 per share. $9,136,0002

OK. with this shorts???

[mikehav]

Well said!

[nwpharmacist]

My, what alot of electrons spilled on RIte AId. Let me be clear, please pay attention. I worked for them til about 9 years ago as a pharmacist. The place is simply run by a bunch of golden retrievers.
Really genuinely stupid people. They bought Thrifty-Payless (West coast)and proceeded to lose most if not all of the pharmacists who had been with Pay N' Save (bought by Thrifty) within two short years; people who had been with them 20-30 years. Pharmacies were enduring (believe it or not) 500% turnover of pharmacists and technicians per year. They had to import Canadian pharmacists because they could keep them. This is because Rite Aid would do their immigration paperwork and the employee would be stuck there or have to find another employer to pick up that expense. Among employees there was speculation that the company was run by the mob. However, everyone rationalized that the mob runs things much better than this. Recall that Martin Grass is (I believe) still in prison for fraud regarding his book-cooking? I have been in touch with pharmacists since then, nothing has changed. If you bought this, weep. If you're buying this, might I interest you in some swamp property?

[ED K]

YOUR ARTICLE IS BASICALLY A RESTATEMENT OF EVERYTHING I'VE HEARD FOR THE LAST SEVERAL YEARS.THIS COMPANY NEEDS SOME REAL LEADERSHIP,IT REMINDS ME OF A MOVIE I SAW CALLED "THE ENDLESS STORY' THE RETORICAL FAILURE OF RITE AID TO RIGHT THE SHIP HAS BECOME, AT BEST,BORING.

[mikehav]

then why are you are reading it & why don't you write something better without the caps lock ON!