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Rite Aid (RAD)

Today’s recommendation, from Todd Johnson, is a turnaround story for long-term investors.

Rite Aid (RAD)
from Dividend Lab

Rite Aid is the nation’s third-largest drugstore chain with 4,604 stores (as of August 31, 2013) and about $25 billion in annual revenues. Rite Aid fills about 297 million scripts each year and has about...

Today’s recommendation, from Todd Johnson, is a turnaround story for long-term investors.

Rite Aid (RAD)

from Dividend Lab

Rite Aid is the nation’s third-largest drugstore chain with 4,604 stores (as of August 31, 2013) and about $25 billion in annual revenues. Rite Aid fills about 297 million scripts each year and has about one-in-four Americans visit its stores each year.

While prescription drugs are its main focus, Rite Aid stores also sell over the counter (OTC) medications, cosmetics, personal care items, household items and food and beverages. The company currently has stores in 31 states and is headquartered in Camp Hill, Pennsylvania.

In 1999, Rite Aid signed an agreement with GNC Holdings Inc. (GNC), a specialty retailer of health and wellness products, to place GNC franchises inside Rite Aid stores. As of June 30, 2013, there were 2,189 GNC franchises in Rite Aid stores.

Rite Aid shares have been on quite a tear of late, with a gain of 353% over the past 12 months, massively outperforming peers Walgreen Co. (WAG) and Caremark Corp. (CVS), and the S&P 500 index. ...

Shares Could Rise to $8 and Beyond

Many would think these shares are best left alone given their strong rise, but as it happens, this star has a lot more energy pent up inside. Wall Street consensus expectations suggest Rite Aid earnings will grow at a 12% clip over the next five years and FAST Graphs estimates that shares could exceed $8 by 2018, a 60% gain over current levels of about $5. I believe Rite Aid earnings could grow at a faster clip and upside could go well beyond $8 if the company successfully executes on its strategy.

While Rite Aid has a lot going for it, the path ahead is not without risks, and shares could well come in for some correction if there is a broad market pullback. So I’d recommend this stock for steely investors who have above-average risk appetite and can hold this company for the next five years to let its business strategy play out.

The Upside

In its most recent quarter ended August 31, 2013 (2Q14), Rite Aid reported GAAP net income of $32.8 million ($0.03 per diluted share), a strong swing to profitability from a net loss of $38.8 million in the year-ago quarter. Its quarterly net income included a $62.2 million charge related to the retirement of some of its long-term debt, which was partly offset by a $23.5 million recovery related to prescription litigation.

The company reported quarterly revenues of $6.28 billion, up $48 million from the year-ago quarter. Gross profit margin increased to 28.93% from 27.45% and Adjusted EBITDA rose 56.2% to $341.6 million, 5.44% of revenue versus 3.51% in the year-ago quarter. Adjusted EBITDA benefited from the introduction of new generic drugs, higher front-end gross margins, cost controls and the settlement of an outstanding prescription drug lawsuit. The graph below shows a steady return to positive gross profit in 2Q12 and strong growth in Adjusted EBITDA.

Same store sales increased 1% in the quarter and included a 1.7% increase in pharmacy sales that was partly offset by a 0.3% drop in front end sales. ...

Net Debt, Interest Expense Trending Down through Debt Refinancing

Rite Aid is heavily focused on reducing net debt. On June 18, 2013, Rite Aid announced its offer to buy back all of its $810 million of 9.5% senior notes that were to mature in 2017. In addition, the company increased its $400 million offering of 6.75% senior notes, due 2021, to $810 million. These transactions were part of management’s debt refinancing plan to manage and reduce $6 billion in long-term debt and save $85 million in annual interest expense.

In 2Q14, total interest expense dropped to $106.7 million from $129 million in the year-ago quarter, while total debt declined to $6.05 billion from $6.16 billion. Rite Aid’s been using free cash to gradually whittle down debt and continued debt reduction would nicely complement a corporate turnaround and potentially make Rite Aid an attractive acquisition target or free it up to make acquisitions of its own.

At quarter end, the company held $144.2 million in cash, $3.2 billion in inventories, $1.9 billion in net property, plant and equipment, and $7.17 billion in total assets. Long-term debt was $5.92 billion and accumulated losses resulted in a stockholders’ deficit of $2.3 billion. ...

Good Progress Towards Strategic Goals

Management’s key goals include reinvigorating top-line revenues, strengthening customer loyalty through innovative and targeted in-store wellness programs, remodeling stores to improve the shopping experience, significantly reducing SG&A expenses, growing EBITDA and proactively managing debt. The company has, to management’s credit, made good progress towards each of these goals with 2.3 million flu shots administered in FY13, over 25 million active loyalty customers, over 1,000 store remodels, operating expense reductions, sustained EBITDA growth over 11 quarters and debt refinancing and pay-down to strengthen the balance sheet. ... Part of management’s turnaround plan is to close underperforming stores to cut losses and expenses.

Execution Risks Remain

Rite Aid is a solid turnaround story but the loss of key executives, their inability to grow top-line revenues, their lack of steep enough discounts to effectively compete, potential litigation or operational blunders could derail this story.

Summary

Rite Aid is executing well towards achieving key operational and financial goals. Shares have risen spectacularly over the past year and should rise significantly higher if the company continues to execute without blunders, but missteps could be very expensive and cause shares to drop.

Therefore, this stock is not for the weak of heart or for those who want to lock in early gains. This is a turnaround story with many challenges helmed by a management team that is capable of delivering success, and buyers should give management the benefit of doubt as they navigate strong industry headwinds.

Todd Johnson, Dividend Lab, www.dividendlab.com, 505-514-0036, October 28, 2013