Rite Aid: Low Priced Dog or Undervalued Drug Store?

By: Steve Rubis

Value investors are often attracted to low priced common stocks. The problem is determining whether or not the low priced stock in question is truly undervalued. Certainly, most would argue that stocks under $10 are there for a reason, yet at the same time there are many which are poised to make a come back. It seems that an Rite Aid (RAD) falls into both categories; many believe it is a complete dog, but at the same time exhibits quite a few value qualities. On Thursday, June 22, 2006, RAD reported its first quarter earnings. The numbers were certainly lower than the previous year’s first quarter, but there are things to be excited about. The rest of this article will outline why we like Rite Aid. Please note that we initiated a 200 share position in pre-market trading (There is a high premium to gain access to such trade – do not trade in after hours!!!!).

Rite Aid is an interesting stock in that many would equate it to being a dog. Here at Research Stocks, we have often thought the same thing. Nevertheless, a quick analysis of the stock led us to believe that it truly is worth considering as an investment. Jim Cramer, of the CNBC show Mad Money, keeps touting this stock as a trade to the $6 range. We believe that investors should hold RAD for the long term. It seems that the turn around is on track, and that if it continues to be successful the true value of this firm will be realized.

Our analysis takes quite a few factors into account and focuses on the Drug Stores industry. Luckily, there are only four stocks in this universe so comparisons are quick and easy. The main companies are Walgreens, CVS, Rite Aid, and Longs Drug Stores. With the exception of Rite Aid, each stock trades at an investment price, meaning considerably above $10. It is for this reason that we like RAD; the company is undervalued on many levels in comparison to the rest of the tiny industry.

Let us begin the analysis by explaining what variables were used to generate our price targets:

Industry Averages
P/E: 18.07
P/S: 0.53
P/B: 2.95
P/EBITDA: 8.90

We start by applying these averages to the current data available for Rite Aid. This yields the following values:

P/E Value: $34.16, EPS (ttm) X 18.07 (Industry Average)
P/S Value: $17.40, (Sales (ttm) X 0.53 (Industry Average)) / Shares Outstanding
P/B Value: $ 6.31, Book Value X 2.95 (Industry Average)
P/EBITDA Value: $10.91, (EBITDA X 8.90 (Industry Average)) / Shares Outstanding
Simple Average: $17.20

Our next calculation is Take Out Value as described in The Five Keys to Value Investing by J. Dennis Jean-Jacque. The equation used is as follows, our illustration shows the calculation for Rite Aid:

EBITDA: $648,600,000
Take out EBITDA Multiple: 8.90 (Industry Average)
Adjustment (Cash – Debt): ($2,974,900,000)
Total Value: $2,797,640,000
Shares Outstanding: 528,900,000
Per Share Price: $16.54

Another value test that we like to perform is the Benjamin Graham Intrinsic Value Equation:

Equation: EPS ((2 * G) + 8.5) * (4.4 / Bond Rate)
*The bond rate we use is the 10 Yr Treasury Note, which is currently 5.175%
**EPS is the trailing twelve months number
***G is the growth rate for the next five years

EPS: $1.89
G: 7.3%
Bond Rate: 5.175%
Value: $37.12
Value (w/o tax credit): $1.96

The problem with our EPS number is a $1.2B deferred tax credit that was taken in March of 2006. This credit has skewed the EPS number, which is closer to $0.10. Such items severely skew the numbers when performing a statistical analysis, the good analyst must compensate accordingly.

Next, we like to analyze the balance sheet to make sure that the company is financially viable. The Altman Z score allows us to calculate a score that will predict bankruptcy with 90% accuracy. The range of scores and predicted outcomes are as follows:

Score of 1.8 or less = high probability of bankruptcy
Score of 1.81 to 3.0 = gray area
Score above 3.0 = unlikely probability of bankruptcy

Rite Aid scores a 3.31 using this bankruptcy test, meaning that despite exorbitant debt, it should not go bankrupt.

Lastly, it seems prudent to look at the franchise price for each Rite Aid store, calculated by taking the market cap and dividing by number of stores. Look at the following data:

Price Per Store:
Walgreens: $8.4M
CVS: $4.5M
Rite Aid: $725K
Longs Drug Stores: $3.5M

Both Walgreens and CVS have over 5,000 stores, while Longs only has 476, and Rite Aid 3,300 plus. It seems that Rite Aid stores have no value in comparison to the rest of the industry. Even with a large amount of debt, the $725K price seems quite low. Such a low store price suggests that the company should be an acquisition target by either Walgreens or CVS. With the amount of cash Walgreens’ has available, it could take out either Rite Aid or Longs with no problem.

Upon review of the above analysis, we think that Rite Aid is an undervalued Drug Store chain. It seems that it would provide value to either of the big two drug stores: Walgreens or CVS if it could be bought out. Our take out price is $16.54, but we think that RAD will be hard pressed to rise above $10, partly due to the earnings issue and large debt position. At a price of $4 or below, it is a buy. Recently, we initiated a position at $4.75, but liquidated upon losing over 10%. This stock is definitely on our watch list going forward.

*This article merely explains how to evaluate a specific equity and the author cannot be held responsible for any money made or lost on the stock. The article is merely an opinion based on my own personal research.