Could Being Undervalued Boost Rite Aid (RAD) Stock?

One reason why RAD bulls think the stock is undervalued.

By Lucas Hahn, InvestorPlace Contributor

http://bit.ly/2x09TSP

Last week brought some good news for holders of Rite Aid Corporation (NYSE:RAD) stock. Rite Aid announced that the FTC had approved its revised deal to sell nearly half of its stores to Walgreens Boots Alliance Inc (NASDAQ:WBA) for $4.38 billion.

Walgreens tried to buy Rite Aid outright in 2015, but the deal was called off in June due to antitrust concerns. Walgreens and CVS Health Corp (NYSE:CVS) are the two biggest drug store chains in the United States, with Rite Aid coming third.

 

RAD stock, however, fell after the deal received approval, and remains down 72.66% year-to-date.

In my previous articles, I listed my concerns with Rite Aid stock.

In my first article, I noted that RAD doesn’t look cheap relative to its two larger competitors, and this is in an industry where size matters. Pharmacies need bargaining power to negotiate deals with drug wholesalers and manufacturers, and Rite Aid’s sale will leave it much smaller.

My second article discussed Rite Aid’s heavy debt load and negative cash flow.  

Other InvestorPlace writers hold bearish opinions as well. In an August article, Will Ashworth noted that the deal with Walgreens would strengthen Rite Aid’s balance sheet but leave it “an also-ran in a very competitive marketplace.”

Rite Aid bulls acknowledge some of these issues, but point to its purchase of pharmacy benefit manager EnvisionRx for $1.8 billion in February 2015.

Here’s how this line of thinking goes: Given Rite Aid’s market capitalization of $2.44 billion, if you assume that a) Rite Aid didn’t overpay for EnvisionRx, and b) EnvisionRx didn’t lose any value in the past two years, then the rest of Rite Aid must be valued at only $644 million.

Valuation of RAD: The Full Picture

First off, as I’ve mentioned in past articles, a company’s market capitalization does not show the whole picture.

There are two sources of external funding for companies. They can issue stock and promise people who buy the stock a portion of the future profits. The other option is to borrow money and promise to pay it back with interest.

A company’s market capitalization does not reflect its entire value, since companies also fund themselves with debt. If you want to buy a company valued at $2 billion which owes $4 billion in debt, you would have to pay at least $6 billion, since you become responsible for its debt.

Likewise, if you want to buy a company worth $4 billion that has $2 billion in cash and no debt, your effective purchase price would be more like $2 billion, since you get the cash afterwards.

Enterprise value takes this into account. To calculate a firm’s enterprise value, add its debt to its market capitalization and subtract cash.  

Rite Aid may have a market capitalization of only $2.44 billion, but it owes about $7 billion in debt, giving it an enterprise value of $9.4 billion.

Subtracting the $1.8 billion leaves the rest of Rite Aid with an enterprise value of around $7.6 billion, not $644 million. Now Rite Aid no longer looks like such a steal.

Political Risks for Pharma Stocks  

What about the second assumption, that EnvisionRx did not lose any value from 2015 to now?

In my April article on Teva Pharmaceutical Industries Ltd (ADR) (NYSE:TEVA), I discussed how events in 2015 shifted the political climate for the industry.

2015 was the year of the Martin Shkreli/Daraprim pricing controversy and the Valeant Pharmaceuticals Intl Inc (NYSE:VRX) scandal, both of which happened around the same time.

And last year, senators railed at Mylan N.V. (NASDAQ:MYL) for quintupling the price of EpiPen allergy shots since 2011. These events raised public awareness of rising drug prices, and politicians in both parties began searching for villains.

Finger pointing followed. Some people blamed drug makers for the rising cost of prescription drugs. Some blamed physicians for prescribing too many drugs. Others blamed health insurers. Drug makers blamed pharmacy benefit managers.

Voters remain concerned over drug prices, and politicians might want to try to force them lower. Whom this burden would fall on is unclear; it’s a complicated system with health insurers, pharmacy benefit managers and drug companies all playing a role.  

Pharmacy benefit managers defended themselves, saying they help keep a lid on drug prices by negotiating with drug makers. An industry group released a plan to cut drug spending by $100 billion over ten years.

The industry is on the defensive. Stocks of pharmacy benefit managers such as CVS and Express Scripts Holding Company (NASDAQ:ESRX) are down since 2015.

Pharmacy benefit manager stocks down since 2015

So the second assumption, that the value of Rite Aid’s pharmacy benefit business didn’t change since 2015, may not hold water either.

As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2017/09/boost-rad-stock-undervalued/.

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