Rite Aid surged 7.5 percent on March 12 after Goldman Sachs analyst Robert Jones said the stock has further to climb, even after more than tripling (RAD:US) last year amid a return to profitability. The $6.5 billion company, which has been refinancing debt and remodeling stores, could interest CVS (CVS:US) Caremark Corp. or Walgreen Co. (WAG:US), BTIG LLC said.
The drugstore operator has the highest free-cash-flow yield among peers and its profit multiple makes it one of the cheapest chains worldwide, data compiled by Bloomberg show. The Camp Hill, Pennsylvania-based company’s northeastern and mid-Atlantic locations would bolster Walgreen’s U.S. presence, according to BB&T Corp., which said selling to a larger rival would help Rite Aid avoid pricing pressure from pharmacy benefit managers.
“There’s a very good, very sensible case to be made for Rite Aid being a target,” William Frohnhoefer, a New York-based analyst at BTIG, said in a phone interview. “They’ve become a much more profitable, much more cash flow generating company over the last couple of years so they’ve become just much more attractive.”
Susan Henderson, a representative for Rite Aid, didn’t respond to a request for comment.
Rite Aid shares rose this week to the highest since October 2001 after Goldman Sachs’s Jones recommended investors buy the stock. Rite Aid will benefit from an expanded drug distribution agreement with McKesson Corp. (MCK:US) and higher exposure than CVS and Walgreen to states that are expanding Medicaid under the Patient Protection and Affordable Care Act, Jones said. He estimates the shares will rise to $8 in the next 12 months, up from a $5 forecast in October.
“We see runway left in the turnaround,” Jones wrote in the March 11 report. Rite Aid closed yesterday at $6.77, up from $1.75 a year earlier.
Today, Rite Aid shares rose 0.6 percent to $6.81.
Chief Executive Officer John Standley has relocated or remodeled more than 1,000 of Rite Aid’s stores. The company has also shuttered underperforming locations, cutting its store count to 4,595 at the end of November, and refinanced debt. After 21 quarters of losses, it’s now had five straight periods of profit (RAD:US).
Rite Aid’s improving financial situation may make a takeover of the company more attractive to its larger rivals because they would be more likely to get cost-saving and revenue benefits from a deal, said Ross Muken, a New York-based analyst at International Strategy & Investment Group LLC.
A combination with Walgreen “is certainly possible,” he said. “It’s also possible for CVS.”
The appeal for both companies would be adding market share to boost their bargaining position with drug distributors, said Frohnhoefer of BTIG. Apart from Rite Aid, there’s no other real target of size that would make a difference for Walgreen, which has a market capitalization of $64 billion, or CVS, which is valued at $86 billion, he said.
“Being able to increase market share like that and being able to show distribution channels that are so massive to the distributors who themselves are also consolidating, it makes sense,” the analyst said. “It would be a good defensive maneuver and at the same time enable them to pick up an asset that has attractive cash flow.”
Rite Aid’s free-cash-flow yield (RAD:US) of 6.3 percent tops every pharmacy and drugstore operator larger than $1 billion globally, according to data compiled by Bloomberg. Even after its gains this year, the drugstore chain is valued at 9.5 times its earnings before interest, taxes, depreciation and amortization, compared with an industry median of about 11, the data show.
The company’s East Coast concentration could raise anti-trust hurdles for CVS, making it a more natural fit for Walgreen, Frohnhoefer said.
Walgreen, based in Deerfield, Illinois, has a strong presence in the Midwest and buying Rite Aid would fill some holes for the company in the northeast and mid-Atlantic regions, particularly in Philadelphia, Washington and Baltimore, and bulk up its California presence, said Andrew Wolf of BB&T.
Potential turnoffs for Walgreen are Rite Aid’s store productivity, which still lags behind its peers, and a more unionized employee base, Wolf said.
Even so, “you’re going to have more bargaining power with the pharmacy benefit managers because you’re a bigger network,” Wolf said. “That’s why the idea is attractive because it really gives them regional scale.”
Rite Aid also could be a target or partner for Express Scripts (ESRX:US) Holding Co., Glen Santangelo, a New York-based analyst at Credit Suisse Group AG, wrote in a January report.
Representatives for Walgreen, Woonsocket, Rhode Island-based CVS and St. Louis-based Express Scripts declined to comment on whether their companies would be interested in buying Rite Aid.
Dane Leone of Macquarie Group Ltd. said a takeover of Rite Aid may be unlikely because its assets are in lower-quality geographical areas that don’t fit with Walgreen’s strategy of building flagship stores in prime locations. CVS has been focusing its acquisition spending on health-care companies, such as specialty infusion services provider Coram LLC which it bought for $2.1 billion this year, he said.
Rite Aid could instead pursue Fred’s Inc. (FRED:US), a regional discount chain with a pharmacy business that’s exploring a sale, Leone, a New York-based analyst, said in a phone interview.
“That would be a possible combination and a possible strategy for Rite Aid to look at,” Leone said.
Fred’s, which said in January it would explore strategic options, has approached potential suitors including CVS, Walgreen, Dollar General Corp. (DG:US) and private-equity firm H.I.G. Capital LLC, people with knowledge of the matter said last month.
The chain is often the only pharmacy in rural areas, which gives it more negotiating power with pharmacy benefit managers and could be a draw for Rite Aid, according to Wolf of BB&T.
Jerry Shore, chief financial officer of Memphis-based Fred’s, declined to comment on the company’s strategic review or whether it has been approached by Rite Aid.
Whether it acquires Fred’s or sells itself to one of its larger rivals, Rite Aid should do something, Wolf said. As a weak No. 3 to CVS and Walgreen in the U.S., Rite Aid is vulnerable to reductions in prescription payouts by pharmacy benefit managers, he said.
“It’s going to be in Rite Aid’s interest to find someone to take them out,” Wolf said.
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