Can Rite Aid’s Stock Go Higher? Here Are Three Factors That Can Do It

+262.59%
Upside
0.65
Market
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Trefis
RAD: Rite Aid logo
RAD
Rite Aid

Just about three months into 2015, the healthcare industry has already seen a lot of action this year. Be it mergers between leading healthcare enterprises, such as Walgreens’ acquisition of Alliance Boots (NASDAQ:WBA) and UnitedHealth’s acquisition of Catamaran (NYSE:UNH), or a billion dollar acquisition for entry into adjacent markets (Rite Aid’s acquisition of EnvisionRx (NYSE:RAD)), it’s all been happening. While the industry continues to offer growth opportunities (driving top lines higher), it also brings along with it a set of risks which hold the potential to drag down bottom lines, which is what really matters at the end of the day. This fear is reshaping the industry on a wide scale and could therefore be a turning point, throwing weaklings out of the race.

Now, there couldn’t be a more important time for investors to take a close look at how these changes could affect companies of their interest. So, we decided to handpick three key factors that could have a significant impact on Rite Aid’s stock price. Note that the potential upside/ downside is indicated in parentheses beside each factor.

View our detailed analysis for Rite Aid

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Generics drugs have traditionally been good for pharmacy retailers’ profits as they provide higher margins than branded drugs do. However, as their prices increased in the recent past and reimbursement rates stayed flat, they’ve led to losses for most drug retailers. To help tackle this issue, Rite Aid entered into a distribution agreement with McKesson (the largest distributor of pharmaceutical and medical supplies in the U.S.) providing purchasing efficiencies and direct-to-store delivery for all its pharmacy products. This somewhat helped the company offset margin pressure arising from low reimbursement rates.

If Payers Design New Formulary Tiers (+20%)

But, more help is on its way to further ease some pressure off margins (for retailers, in general). The amount that retailers get reimbursed from payers varies with the type of drug. Branded drugs, specialty therapies and generics are usually separated into different tiers, each of them having different reimbursement rates. However, with generic price inflation, the disparity between prices within the generics category has increased. According to a study conducted by the Drug Channels Institute [1], 50% of the drugs, in their survey sample, increased in cost and 50% declined between July 2013 and July 2014 (though the magnitude of increases is significantly higher than that of decreases).

In such a situation, it is necessary to treat each generic drug differently when it comes to reimbursement rates, as one solution for all doesn’t work. Therefore, payers are working on creating a tiered pricing system for generic drugs that would require members to pick up more of the cost. While this pricing system is still in its formative stages, when put into effect, it could reduce drug acquisition costs for pharmacy retailers.

Per the current scenario, we expect the comapny’s EBITDA margin to marginally increase from its current level of 8.6% to 8.9% till the end of our forecast period. However, if the proposed new pricing system is brought into effect, it has the potential to push margins up. Even if we consider a 1% increase in the company’s EBITDA margin in the next two fiscal years (FY’16 and FY’17), it translates to a 20% upside to our current price estimate.

If EnvisionRx Acquisition Helps Reduce Drug Acquisition Costs (+10%)

Similar benefits (i.e. increase in the company’s EBITDA margins) could also arise from the company’s recent acquisition of EnvisionRx, a national pharmacy benefit management (PBM) company. As Rite Aid gains access to the 13 million individual accounts that EnvisionRx manages [2], it will benefit from increased negotiating power with drug manufacturers. Moreover, EnvisionRx is a growing business that has seen its sales climb from less than $2 billion in 2011 to an estimated $5 billion in 2015. Future growth in the PBM business will likely translate into even more negotiating power and margin benefits (than the assumed 0.5%). However, increasing competition in the PBM market (as consolidation resulted in formation of large enterprises with more power) has led us to tone down our expectations.

Note that the expected synergies will likely be realized in the long term. As mentioned above, we expect Rite Aid’s EBITDA margin to marginally increase from its current level of 8.6% to 8.9% till the end of our forecast period. Based on the assumption of a 0.5% increase in EBITDA margin in FY17 and FY18 combined, benefits from integration of the PBM business translate to a 10% upside to our current price estimate.

If EnvisionRx Acquisition Leads To Gain In Pharmacy Market Share (+18%)

The PBM business (EnvisionRx) is also likely to boost Rite Aid’s pharmacy retail business. A portion of the company’s PBM accounts, i.e. the individuals whose insurance plans it manages would now be drawn towards Rite Aid stores to get their prescriptions filled (~40% of CVS’ PBM prescriptions go through its own channels) [3]. As margins in the pharmacy retail business are much higher than those in the PBM business, an increase in the share of prescription revenues (out of total revenues) will translate to increase in the overall margin as well. For example, CVS’ makes an EBITDA margin of about 16% in its retail business, compared to a little over 5% in PBM (based on FY 2014 results).

According to our current forecast, Rite Aid’s share of the total prescriptions filled in the U.S. is expected to marginally increase from the current level of 7.2% to 7.5% by the end of Trefis forecast period. We believe that the above mentioned benefits could lead to an additional gain of about 1% in the company’s prescription share, taking it to 8.5% by the end of our forecast period. Under the assumption that the share gain will be achieved (uniformly spread) over a period of 3 years from FY 2016 to FY 2018 (again, delayed due to integration), it translates to an upside of about 18% to our current price estimate.

Conclusion

While we have tried to quantify how each of these factors could individually impact Rite Aid’s stock price, they could also act in combinations and result in much higher upside. For example, a combination of factors two and three discussed above (i.e. gain in prescription share and reduction in drug acquisition costs) presents a total upside of about 27%. Our interactive model allows users to input their own assumptions (for example, a 0.5% share gain or 0.5% margin gain or changes in various other drivers) and arrive at different price estimates. Here is our home page for Rite Aid where all this could be done.

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Notes:
  1. Retail Generic Drug Inflation Reaches New Heights []
  2. Rite Aid to buy pharmacy benefit manager EnvisionRx for $2 bln []
  3. Annual Analyst Day 2014, CVS Health Events, December 16, 2014 []