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The Rumors Facts of a Closely Watched Pharmacy

The essence of successful investing is very simple: Follow the earnings.

Earnings are the fundamental driver of stock prices. That’s it.

It’s something that has been proven time and again in academia and on Wall Street.

And yet too many investors pin their hopes for investment success on unreliable data – like speculation.

Here’s a perfect example of why it’s important to follow what you know to be true and to turn a deaf ear to rumors.

Shares of Rite Aid (RAD) fell more than 4.2% on Thursday, despite posting better-than-expected fourth-quarter fiscal 2015 results.

So what caused the stock price to tank on the better-than-expected quarterly results?

In a word… earnings!

Or, in Rite Aid’s case, the lack of earnings for fiscal 2016.

You see, the Pennsylvania-based retail drug store chain issued earnings guidance of $0.19 to $0.27 per share for the new fiscal year. The guidance is significantly below previous analyst expectations of $0.43.

The company said its diminished outlook is a result of planned wage and benefit increases, as well as a reimbursement rate environment that remains challenging.

The news surprised many on Wall Street after the company’s outperformance last quarter, which showed spectacular improvement across the board.

Fact: Impressive Q4 FY 2015 Results

Strong prescription revenue (accounting for about 68% of sales) helped propel same-store sales 4.5% higher by 90 basis points over consensus estimates.

The drug store saw pharmacy comps rise by 5.7%, while front-end comps went up 2%.

The strong sales pushed Rite Aid revenue to $6.8 billion, a 3.8% increase year over year.

The company’s quarterly net income skyrocketed to $1.84 billion ($1.79 per share) from $55.4 million ($0.06 per share) in the same quarter a year ago.

True, the catalyst for the huge net income increase was a one-time reduction in the company’s deferred tax asset allowance of $1.84 billion, which added $1.67 per share to the company’s net income.

Still, the net income without the tax benefit was twice analysts’ expectations of $0.06 per share. This is proof that the company has succeeded in increasing shareholder value in the last three years.

Rumor: Acquisition Coming Soon

Here’s where reality collides with speculation. Wall Street strongly speculates that CVS Health (CVS) or Walgreens Boots Alliance (WBA) could be plotting to take over Rite Aid.

The persistent rumors have helped push shares of Rite Aid up since early March. We’ve seen higher volume of open interest in long calls with higher implied volatility – which is leading some to believe that Rite Aid could see an offer in the coming months.

Now, while there’s always a chance that Rite Aid could be a target… at current levels, the stock doesn’t appear to be a good candidate for a takeover.

You see, Rite Aid has an $8.2-billion market cap, but it also has an enterprise value of $14.6 billion. This means the company is carrying a significant load of debt, and it’s reflected in its EV/EBITDA ratio of 11.96.

An enterprise ratio this high isn’t conducive to a takeover, especially for the retail pharmacy business with its historically low margins.

And with consolidation being the road to least resistance for growth in the industry, we can logically expect to see current debt levels increase further.

Case in point: Look to the company’s recent acquisition of EnvisionRx, which is accompanied by $1.8-billion worth of notes carrying a coupon of 6.125%.

Lastly, by conducting a discounted cash flow (DCF) analysis using a 7.5% average revenue growth (optimistic), the stock has a fair market value of approximately $8.50. In other words, the stock is fairly valued after Thursday’s 4% decline.

A Very Good Lesson for Investors

In short, Rite Aid doesn’t make a good takeover target at current valuations. Any company buying it would do so at a significant premium.

That being said, investors and shareholders alike should take heed to my warning.

Watch earnings. They’re the real drivers of RAD stock.

Good investing,

Richard Robinson

Richard Robinson

, Ph.D., Equities Analyst

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