2 Drug Retailers To Buy, 1 Potential Takeover Target
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
After the Supreme Court upheld the constitutionality of the Affordable Care Act, many healthcare investors are naturally wondering how the drug retail market will fare. In my view, a larger insured population equals more business. On the other hand, the Act also imposes several taxes on drug manufacturers that will reduce innovation and limit the degree of upside. That is to say, I anticipate less "blockbuster drugs" that would have otherwise produced strong free cash flow for the retailers. Even still, I find the degree of risk/reward to be slightly favorable in Rite Aid (NYSE: RAD) and very favorable in Walgreen (NYSE: WAG) and CVS (NYSE: CVS).
CVS & Walgreens
If you apply a 7.8% discount rate on a forecast of 11.8% growth and 1.5% into perpetuity, the fair value of CVS' stock is $41.50, which indicates minimal downside. Taking a discount rate of 7% and a terminal EBITDA multiple of 6.5x, the stock should be worth nearly $54. Integration with Caremark in streamlining benefits has proceeded smoothly while front-end comps have held up. In terms of margins, SG&A costs have been declining as a percent of revenue and are expected to continue to decline while EPS is forecast to take off in 2012 and decelerate to around 14.5% by 2014.
At around a multiple greater than 17x, CVS has enough growth ahead to justify its current valuation. Pharmacy benefits has seen a 98% customer retention rate, and the Universal American takeover will help the business continue to take away market share from Walgreens after the Express Scripts dispute. The lack of volatility on top of a reasonable 1.5% dividend yield makes CVS a compelling "buy".
While Walgreens may have lost the Express Scripts network, it is still overly discounted at around 12x past earnings. Consensus estimates for Walgreen's EPS forecast that it will grow by 0.4% to $2.65 in 2012 and then by 10.6% and 7.5% in the following two years. This projection is relatively "soft" against what is projected for CVS. The decision by management, however, to boost the dividend yield was well-timed with the acquisition of Medco. This purchase enables the company to not just take the attention off of Express Script but to set the foundation for takeover activity that will enable to scale up to CVS..
Rite Aid
Rite Aid is the struggling drug retailer that is not for the faint of heart. It has been bleeding money, but it is heading towards more positive territory on the bottom-line. Consensus estimates for Rite Aid's EPS forecast that its losses will diminish 51.2% to -$0.21 in 2013 and then by 42.9% and 58.3% in the following two years. Rite Aid has already generated strong returns for the year to date as risk discounting has begun to dissipate. With adjusted EBITDA up for the fifth quarter in a row, investors are becoming more confident about the underlying fundamentals despite a history of recent losses.
Ultimately, I believe that Rite Aid could become either an activist or takeover target. The business is cheap enough for a small hedge fund to build a large stake in and lobby for change. That will likely only occur, however, if Rite Aid misses expectations by a mile or fails to improve the financial position. There is a lot of value to extract through selling off stores to brands that can leverage the established location. It may be a takeover target altogether in the sense the stores could be used to improve, say, CVS or Walgreen's access to attractive patient populations in geographies that were currently untapped. Although I do not see this as terribly likely, it is possible and worth an investment under the context of the turnaround that is happening right now anyway.
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