Rite Aid traditionally has been one of those stocks that respectable investors avoided at all costs. Subpar execution and dismal earnings characterized the company’s past. However, new changes at Rite Aid paint a different picture of the future and force us to ask ourselves, can this once unloved company make a lazarus-like comeback from the grave? My answer is a resounding YES. In many ways however, a large part of the rebound has already occurred. Just take a glance at the chart you can see that Rite Aid has been blessed with a glorious levitating ability, allowing the stock to rocket up over 100% year-to-date. Skeptical as you undoubtedly are with any stock that has doubled year-to-date, let me say that I believe this stock can go demonstrably higher from here. I believe this stock price appreciation will be driven both by accelerating EPS growth and P/E multiple expansion.
Rite Aid offers an attractive turn around play and the company has taken great strides on the path to progress under their new CEO, John Standley. Mr. Standley assumed his position as CEO in late 2009 and since then has transformed a near bankrupt enterprise into a prosperous and burgeoning pharmacy business. Departing from past standards of ineffective leadership, unreasonable compensation, and lackluster returns, Mr. Standley has chosen a different course for his company’s future. The Wellness+ program has increased customer loyalty and helped to drive steady revenue growth. The company plans to remodel 500 additional locations providing a foreseeable increase in top line growth. Moreover the company’s location reorganization strategy also aims to close unprofitable stores adding to the bottom line. The company didn’t even have an iphone or android app before he came along. I’m not arguing however, that Mr. Standley is superman. My emphasis on Rite Aid’s management is simply to demonstrate the change in corporate governance and management under his leadership.
While growing the bottom line, the company has also reduced excess leverage. From 2010, the company’s debt has declined from roughly $6.4 billion to $5.9 billion. Moody’s has stated that they will consider upgrading Rite Aid senior unsecured debt if the company can achieve debt to EBITA ratio of less than 7 and an EBITA to interest expense ratio of 1.25 or more. If you take a glance at Rite Aid’s statement’s they really aren’t that far away from either of those conditions and if the company continues the way it has they are likely to receive a credit rating increase in the foreseeable future. They recently refinanced an issue due 2017 and extended the maturity date to 2020 while lowering the interest rate expense by $85 million. The company still has a large quantity of callable senior unsecured debentures due 2020 that can be refinanced at much lower rates. By my estimates the company could easily save an additional $50 million a year from further refinancing, representing incremental savings of around .055 per share. For a stock trading for less than $3, those potential savings are not insignificant.
From a growth perspective, the company is in the early innings of a dynamic paradigm shift in the pharmacy business which comprises two thirds of their revenue. First off, Medicare Part D, the prescription drug plan service that went into effect in 2006, is expected to nearly double by 2022 driven largely by the retirement of baby boomers. One negative for the company that could be viewed as a potential positive is that they are not a preferred plan provider like Walgreens. Customers suffer financially for choosing Rite Aid over it’s larger competitor, Walgreens. I expect Mr. Standley to achieve to preferred status, but this is a process that will take time. Aside from Medicare Part D, the pharmacy business is a direct beneficiary from the Patient Protection and Affordable Care Act which will only be fully implemented by 2016. The last major source of secular growth over the coming years comes from the so called “drug patent cliff.” Rite Aid, along with other pharma companies benefit from the patent expiration of brand name drugs and the introduction of generic drug which represent higher margins and are accretive to the bottom line. Evaluate Pharma estimates that $290 billion of revenue is at risk due to patent expirations between now and 2018. Much of that revenue will be lost to generics, but will be more evenly shared with pharmacies like Rite Aid, leading to higher gross margins and enhanced profitability.
On a valuation standpoint, Rite Aid trades is cheap relative to its peer group and relative to the broader market. The stock trades at a P/E of 12 with price to cash flow ratio of 4. Based on consensus the company has a forward PEG ratio of .9 reflecting good growth and a low P/E multiple. One reason for the low multiple is that Rite Aid’s fiscal 2013 results have benefitted from the dispute between Walgreens and Express Scripts. Management has said that they are likely to end on the lower end of guidance if the dispute is resolved as former walgreens customers migrate back to their original pharmacy provider. The other big concern I have for Rite Aid is their excessive debt position of which roughly $2 billion is variable rate debt based off LIBOR.
When everything is considered, I still believe Rite Aid offers incredible upside potential for anyone willing to hold this name for the long run. The are risks in this name for sure given their obvious balance sheet challenges and tough competition. I wouldn’t recommend this name for a retirement account or anyone without the intestinal fortitude to endure a loss, but I believe the company’s long term prospects are attractive nonetheless. You might also consider taking a position in Walgreens to hedge out the risk to Rite Aid associated with the potential resolution of the Express Scripts dispute.