Rite Aid (NYSE:RAD) got a pop on Wednesday, September 11, to a new high of $3.75 as CNBC's Halftime Report analyst suggested an eventual takeover in Rite Aid's future . This rumor has been whispered before; investors must wonder if it is likely, and if an acquisition is needed to create larger gains for Rite Aid.
Will it be acquired?
Since Rite Aid turned profitable late last year, and began to see increased same-store sales , investors and analysts alike have entertained the idea of a potential Walgreen (NASDAQ:WBA) or CVS (NYSE:CVS) takeover. Strategically, it makes sense.
Rite Aid has a market cap of just $3.3 billion, yet the company has annual revenue of more than $25 billion. Therefore, either CVS or Walgreen could acquire Rite Aid's revenue at a fairly cheap price, and the acquisition would provide significant growth.
Because of the fact that new generic introductions are boosting margins for pharmacies at a rapid rate – generic drugs have higher payouts to pharmacies – it seems more likely that one of the large pharmacies would take a serious look at Rite Aid, now more than ever. Moreover, the rate at which new generic drug introductions are expected to increase over the next three years makes this interest even more appealing. But unfortunately, I don't see it ever happening.
To explain, think back to AT&T's (NYSE:T) attempted acquisition of T-Mobile. The Federal Communications Commission – or the government – blocked its proposal, finding that the merger would create an unfair advantage and negatively impact the competitive effect of the free market. Specifically, the FCC's comment was, "the transaction would decrease competition, innovation and investment, and harm consumers ."
Of course, AT&T argued against the FCC's response, but ultimately AT&T lost. For an industry comparison, there are much fewer telecom companies than small pharmacies in the U.S. CVS, Walgreen, and then Rite Aid are the top three pharmacies, but it's difficult to imagine a scenario where the government allows the merger of either CVS or Walgreen with Rite Aid due to the reasons noted in the AT&T/T-Mobile deal.
Hence, it is possible that we see a proposal of sorts and that rumors continue to build, but the likelihood of Rite Aid being acquired is slim to none.
Does an acquisition matter?
Thankfully, it really doesn't matter for current investors if Rite Aid is acquired or not.
It's no secret that Rite Aid has lower margins, a higher debt-to-assets ratio, and its growth is not nearly as impressive as either Walgreen or CVS. In fact, Walgreen and CVS are both exploding with comparable-script growth , while Rite Aid's script revenue is flat to slightly lower year over year.
However, these Walgreen and CVS strengths have little impact on the future of Rite Aid's stock. The reason is that Rite Aid is now profitable, as last year was its first full year of profitability in more than half a decade.
In the first two quarters of 2013, Rite Aid's profit is nearly double 2012's full-year profit , and what's impressive is that new generic introductions are only going to help improve margins . As a result, Rite Aid's price to sales ratio comes into play, because I would challenge that Rite Aid could double in price without seeing any revenue growth, and without being acquired.
Valuation equals upside
The reason Rite Aid could double without any revenue growth is that it trades at just 0.13 times sales. In comparison, CVS and Walgreen trade at 0.59 and 0.67 times sales, respectively. Granted, both Walgreen and CVS are more efficient companies, but as Rite Aid's margins improve and it pays its debts, it becomes more deserving of the premium that has been awarded to its industry peers.
Thus, if Rite Aid trades at 0.3 times sales and continues to restructure its business and profit from new generic introductions, its stock would be more than double its current price. Moreover, at 0.3 times sales, Rite Aid would STILL trade at a 50% discount to its peers! As a result, I hardly believe that an acquisition is necessary as the next catalyst for Rite Aid.
However, because of Rite Aid's valuation relative to its peers, I think it is clear to see why both Walgreen and CVS might bid to acquire Rite Aid. Either way, it's setting up to be an interesting and potentially lucrative year(s) ahead.
Brian Nichols is long Rite Aid. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.