How to Get Growth at a Reasonable Price Out of a Takeover Target
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Rite Aid (NYSE: RAD) is a major growth opportunity, but also a takeover candidate. The drug company is up over 25% since last week thanks to quarterly results that showed profitability for the first time in over five years, driven by an increase in prescriptions. Rite Aid has posted losses since its 2007 acquisition of the Brooks and Eckerd chains that overloaded it with debt. New income for its recent quarter came in at $62 million, versus a net loss of $52 million on a year over year basis. Billionaires Jim Simons, Israel Englander and Ken Griffin are all big-name investors in Rite Aid (check out Ken Griffin's newest picks).
Fueling Rite Aid's recent strong performance is its market share infringement thanks to the Walgreen (NYSE: WAG) - Express Scripts (NASDAQ: ESRX) debacle. Although the duo's contract was renegotiated several months later, Rite Aid and CVS Caremark (NYSE: CVS) are still benefiting from the dispute.
Express Scripts trades in line on a valuation basis - 0.4x sales and 14x earnings - but does have the highest growth prospects of the five stocks listed with a 18% 5-year EPS CAGR. George Soros upped his stake in Express Scripts by over 50% in 3Q (see George Soros' newest picks).
Rite Aid, meanwhile, is the U.S.'s No. 3 drugstore chain behind Walgreen and CVS. Rite Aid's stock trades with a market-cap around $1.1 billion, compared to major peers Walgreen ($35 billion) and CVS ($60 billion), that trade much higher. Both Walgreen and CVS also have solid cash positions, $1.8 billion and $1.2 billion, respectively. We believe that either major competitor can easily purchase Rite Aid, as the companies' last major acquisition was of Duane Reade by Walgreen in 2010, for $1.1 billion. Steven Cohen of SAC Capital was one of Walgreen's big fans last quarter, upping his stake over 10,000% (see Steven Cohen's big bets).
So what about the valuation?
Walgreen and CVS trade relatively in line on a number of fronts, but Walgreen pays a 3% dividend yield, compared to CVS at 1.9%. They trade in line on a P/S, P/E, operating margins and debt load basis. Stacking Rite Aid up against these two major pharma companies allows us to see it at a much greater discount - 0.1x sales and 4x cash flow - compared to its major peers - 0.5x sales and 10x cash flow.
Various cost-cutting initiatives and debt refinancing efforts should also give Rite Aid investors reasons to be cheery. Same-store sales have generally improved, though that metric declined in the latest quarter as a heavier-than-usual introduction of generic drugs hurt the industry in general.
Last but certainly not least, Cardinal Health (NYSE: CAH) is one of the top healthcare service companies, and also distributes branded and generic pharmaceuticals, in addition to over the counter products. Cardinal trades on the cheap end of the industry at 0.1x sales and 10x cash flow. We remain cautious about this cheap valuation, however, given the company's low 5-year expected earnings growth rate of 8%, and 2% operating margin.
To recap: Rite Aid went relatively unnoticed until last week, but cost-cutting endeavors and attempts to lower debt make it a solid turnaround play going forward. With its strong generic segment, Rite Aid is expected to continue to grow nicely and also is an appealing takeover target. We like Rite Aid not only for its growth opportunities, but also its takeover potential.
This article is written by Marshall Hargrave and edited by Jake Mann. They don't own shares in any of the stocks mentioned in this article. The Motley Fool owns shares of Express Scripts. Motley Fool newsletter services recommend Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!