Wall Street warms to Rile Aid's strategies

Drug Store News, Oct 5, 1998 by Liz PARKS

Financial analysts applaud solid operation, predict continued growth in earnings

Six months through its 1999 fiscal year, many security analysts considered Rite Aid an undervalued stock. At the end of its fiscal year (Feb. 28), Rite Aid stock was selling at 22 times earnings, while CVS was selling at 28 times and Walgreens at 40 times earnings.

While financial analysts feel Rite Aid's stock is undervalued, these professionals, who follow the drug chain industry, like what they see at Rite Aid in terms of debt ratio, store upgrade and expansion plans and senior management. And, they predict a strong future for the chain.

Wall Street analysts who follow Rite Aid say the stock is undervalued for several reasons: primarily because Rite Aid takes more risks and carries a higher debt level than its two closest chain drug competitors, Walgreens and CVS; and partly because Rite Aid's financial performance has not been as consistent nor as stellar as the competition's.

"Rite Aid is undervalued in relation to its peers," said Eric Bossard, a senior analyst at Cleveland-based Midwest Research. "People on Wall Street have disrespect for Rite Aid's story.

"Rite Aid was so aggressive with Revco, so sure the acquisition was going to be completed, that it left a bad taste when it fell through," he said. "There's also the perception of the Street that Rite Aid's assets aren't as high in quality as Walgreens, primarily because of its smaller stores and the locations. But, that has been changing very quickly.

"I expect Rite Aid's earnings to grow between 15 percent and 18 percent in the next three years, while sales will grow 12 percent to 13 percent. As earnings continue to grow, its stock should rise," Bossard added.

Mike Glover, securities analyst for St. Petersburg, Fla.-based Raymond James, said, "Rite Aid has traditionally been undervalued, but the degree of discount today is certainly not justified.

"Rite Aid's done a lot of acquisitions, and, as a result, they've had to take some sizable charges against earnings," he commented. "It was the right thing to do because they are repositioning their store base by opening larger stores, free-standing stores and gaining market share through acquisitions.

"But, some investors may have questions about the quality of their earnings," Glover added. "It seems like every other quarter, there's a charge against earnings, where a chain such as Walgreens never takes a charge unless it's mandated for some accounting reason. However, Rite Aid is a very attractive value relative to its peers."

Debt

Rite Aid's high debt levels have scared some investors, but many analysts say Rite Aid's current debt is manageable.

Jonathan Ziegler, a San Francisco-based securities director for New York-based Salomon Smith Barney, noted that Rite Aid has $2.5 billion in debt on its balance sheet, while Walgreens has virtually no long-term debt. But, he said, the key question is whether the debt Rite Aid is carrying is manageable.

"I don't think they have too much debt," he said. "In a business where you generate considerable cash, their debt is manageable given their asset base.

"They compete in a very stable industry," he added. 'They are not affected by the Asian crisis, and the Asian crisis may even benefit them because it could lower their costs of importing seasonal and other goods."

Bossard, at Midwest Research, said, "Rite Aid is not highly leveraged relative to everyone else. In 1998, for example, the chain had a total capitalization (percentage of its capitalization from debt relative to equity) of about 48 percent, which compares to 35 percent for Wal-Mart, Kmart and Dillard's, 27 percent for Best Buy, 70 percent for Sears, 20 percent for CVS and 10 percent for Walgreens.

"A capitalization rate of 35 percent to 45 percent is fine because if you can borrow at low interest rates (between 6 percent and 6.5 percent), and you can invest that in stores and acquisitions that generate more than 6 percent or 6.5 percent, you come out ahead," he said.

"Rite Aid leveraged at 48 percent is no big deal. They're in a stable business with a stable cash flow," Bossard stated.

Philip Muldoon, first vice president of research at Cleveland-based McDonald & Go. Securities, said he'd prefer less debt to more, "But, given what Rite Aid's done, and given their cash flow, their debt is not outrageous.

"Rite Aid's strategy is to use a combination of cash and stock to make acquisitions and that's raised their debt higher, but I have no problems with their strategy. It's working. They can support their debt," Muldoon added.

Debra Levin, security analyst at New York-based Morgan Stanley Dean Witter, added that while Rite Aid's financial strategies have been "very aggressive, they've been absolutely necessary because Martin Grass inherited a store base that was outdated and outmoded. They've built more than 1,000 fresh new stores in the past three years, but with 4,000 stores as their base, they still have a significant portion of work to do.

"But, they can afford to open new stores aggressively and to pay down debt at the same time. They have a strong cash flow and strong senior management. They're planning their growth," Levin said.